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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 1-11921
E*TRADE GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-2844166
(State or other jurisdiction (I.R.S. Employer Identification
of incorporation or organization) Number)
FOUR EMBARCADERO PLACE, 2400 GENG RD. PALO ALTO, CA 94303
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (650) 842-2500
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
TITLE OF EACH CLASS
COMMON STOCK - $0.01 PAR VALUE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [ x ] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [ ]
As of December 12, 1997, the aggregate market value of the voting stock held
by nonaffiliates of the registrant was approximately $698,900,000.
The number of shares of Common Stock outstanding as of December 12, 1997 was
38,806,308 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Definitive Proxy Statement relating to the Company's 1998 Annual Meeting to be
filed hereafter (incorporated into Part III hereof).
E*TRADE GROUP, INC.
FORM 10-K ANNUAL REPORT
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1997
TABLE OF CONTENTS
PAGE
----
PART I
Item 1. Business.......................................................... 3
Item 2. Properties........................................................ 18
Item 3. Legal Proceedings................................................. 18
Item 4. Submission of Matters to a Vote of Security Holders............... 19
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters........................................................... 19
Item 6. Selected Financial Data........................................... 21
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................. 22
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........ 28
Item 8. Financial Statements and Supplementary Data....................... 29
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.............................................. 45
PART III
Item 10. Directors and Executive Officers of the Registrant................ 45
Item 11. Executive Compensation............................................ 45
Item 12. Security Ownership of Certain Beneficial Owners and Management.... 45
Item 13. Certain Relationships and Related Transactions.................... 45
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K... 46
Exhibit Index.............................................................. 46
Signatures................................................................. 49
The page numbers in this Table of Contents reflect actual page numbers, not
EDGAR page tag numbers.
----------------
UNLESS OTHERWISE INDICATED, REFERENCES TO "COMPANY" MEAN E*TRADE GROUP, INC.
AND ITS SUBSIDIARIES, AND REFERENCES TO "FISCAL" MEAN THE COMPANY'S YEAR ENDED
SEPTEMBER 30 (E.G. "FISCAL 1997" REPRESENTS THE PERIOD OCTOBER 1, 1996 TO
SEPTEMBER 30, 1997).
2
PART I
ITEM 1. BUSINESS
Except for historical information contained herein, the matters discussed in
this report contain certain forward-looking statements that involve risks and
uncertainties that could cause actual results to differ materially from those
anticipated in such forward-looking statements.
E*TRADE Group, Inc. ("E*TRADE" or the "Company") is a leading provider of
online investing services and has established a popular, branded destination
Web site for self-directed investors. The Company offers automated order
placement and execution, along with a suite of products and services that can
be personalized, including portfolio tracking, Java-based charting and quote
applications, real-time market commentary and analysis, news and other
information services. The Company provides these services 24 hours a day,
seven days a week by means of the Internet, touch-tone telephone, including
voice recognition, online service providers (America Online, AT&T WorldNet,
CompuServe, The Microsoft Network and Prodigy), interactive television and
direct modem access. E*TRADE's proprietary transaction-enabling technology
supports highly automated, easy-to-use and cost-effective services that
empower its customers to take greater control of their investment decisions
and financial transactions. Further, the Company believes that its technology
can be adapted to provide transaction-enabling services related to other
aspects of electronic commerce.
Advances in telecommunications and information technology have fundamentally
altered the way individuals conduct business. For example, the development of
the microprocessor and the personal computer revolutionized the way
individuals use computers by providing inexpensive and powerful capabilities
to them. Consumers have embraced the personal computer and expressed strong
preferences for the convenience and control it provides. In a similar fashion,
consumers also have begun using a variety of other electronic devices such as
the automatic teller machine ("ATM") and the facsimile machine, which are now
seen as valuable tools for expediting and controlling transactions and
eliminating human intermediaries.
As of September 30, 1997, the Company had over 225,000 accounts (with assets
under management in excess of $7.7 billion) representing a compounded annual
growth rate in new accounts since October 1, 1994, of 134%. Average daily
transaction volumes were approximately 25,600 in September 1997, as compared
to approximately 8,400 transactions per day in September 1996. For the month
ended September 30, 1997, the Company opened an average of 883 new accounts
per day with average daily deposits of $17 million. The Company began offering
online investing services through the Internet in February 1996 and it is the
Company's most rapidly growing channel. Transactions over the Internet
represented 63% of the Company's September 1997 transaction volume.
The Company operates in a single industry segment: securities brokerage and
related investment services. No material part of the Company's consolidated
revenue is received from a single customer or group of customers, or from a
foreign corporation.
The Company was incorporated in California in 1982 and was reincorporated in
Delaware in July 1996. The Company's principal corporate offices are located
at Four Embarcadero Place, 2400 Geng Road, Palo Alto, CA 94303, and its
telephone number is (650) 842-2500.
SERVICES AND PRODUCTS
The Company's services are based on proprietary transaction-enabling
technology and are designed to serve the needs of self-directed investors. The
Company's services include fully automated stock, option and mutual fund order
processing via personal computer or touch-tone telephone, including voice
recognition, online investment portfolio tracking and financial market news
and information. The Company offers its services to consumers through a broad
range of electronic gateways, including the Internet, touch-tone telephone,
including voice recognition, online service providers (America Online, AT&T
WorldNet, CompuServe, The Microsoft Network and Prodigy), interactive
television and direct modem access. All records are maintained on one
centralized system, so that customers have access to current account
information regardless of which gateways they are using.
3
The Company continually strives to increase the functionality of its
services, as well as to offer new services that enhance customers' online
investing experiences. The Company's services give consumers increased control
of their personal investments by providing a direct link to the financial
markets and to financial information through a personalized user interface.
The Company's existing services and product offerings are described below:
Stock, Options and Mutual Funds Trading
Customers can directly place orders to buy and sell Nasdaq and exchange-
listed securities, as well as equity and index options, and mutual funds
through the E*TRADE automated order processing system. E*TRADE supports a
range of order types, including market orders, limit orders (good-till-
canceled or day), stop orders and short sales. System intelligence
automatically checks the parameters of an order, together with the customer's
available cash balance and positions held, prior to executing an order. All
listed market orders (subject to certain size limitations) are executed at the
National Best Bid/Offer ("NBBO") or better at the time of receipt by the third
market firm or exchange. The NBBO is a dynamically updated representation of
the combined highest bid and lowest offer quoted across all United States
stock exchanges and market makers registered in a specific stock. Eligible
orders are exposed to the marketplace for possible price improvement, but in
no case are orders executed at a price inferior to the NBBO. Limit orders are
executed based on an indicated price and time priority. All Nasdaq market
orders (subject to certain size limitations) are executed at the Best
Bid/Offer (Inside Market) or better at the time of receipt by the market
maker. All transaction and portfolio records are automatically updated to
reflect trading activity. Buy and sell orders placed when the markets are
closed are automatically submitted prior to the next day's market opening.
Mutual fund orders received by 4:00 p.m. Eastern time are purchased at the net
asset value of the fund as of the day of purchase. Account holders receive
electronic notification of order executions, printed trade confirmations and
detailed statements. The Company also arranges for the transmittal of proxy,
annual report and tender offer materials to customers.
Market Data and Financial Information
During trading hours, E*TRADE continuously receives a direct feed of
detailed quote data, market information and news. Customers can create their
own personal lists of stocks and options for quick access to current pricing
information. E*TRADE provides its customers free access to 20-minute delayed
quotes, including stocks, options, major market indices, most active issues,
and largest gainers and losers for the major exchanges. Users are alerted when
there is current news on an identified stock or when a stock has reached a
user-defined price threshold. Through its alliances, the Company also provides
immediate access to breaking news, charts, market commentary and analysis and
company financial information.
Upon placing an order, the customer is provided with a real-time bid or ask
quote at no extra charge. For $30 per month, individual investors can obtain
unlimited real-time quotes and market data. The Company's Web site provides
links to other business and financial Web sites, including the CNN Financial
Network and the EDGAR database, which provides access to SEC filings of public
companies.
Portfolio Tracking and Records Management
Customers have online access to a listing of all their portfolio assets held
at E*TRADE, including data on the date of purchase, cost basis, current price
and current market value. The system automatically calculates unrealized
profits and losses for each asset held. Detailed account balance and
transaction information includes cash and money fund balances, buying power,
net market portfolio value, dividends paid, interest earned, deposits and
withdrawals. Brokerage history includes all orders, executions, changes and
cancellations. Tax records include total short-term or long-term gain/loss and
commissions paid. Customers can also create "shadow" portfolios to include
most financial instruments a customer is interested in tracking--for example,
assets held at another brokerage firm. These shadow portfolios can include
stocks, options, bonds and most mutual funds.
4
Cash Management Services
Customer payments are received through the mail, federal wire system or the
Internet and are credited to customer accounts upon receipt. The Company also
provides other cash management services to its customers. For example,
uninvested funds earn interest in a credit interest program or can be invested
in one of five money market funds. In addition, the Company provides free
check-writing services with no minimum through a commercial bank and is
exploring the expansion of these services. The Company, through its strategic
relationship with National Processing Company, has expanded its cash
management offerings to include electronic funds transfer via the Internet and
an automatic deposit program to allow scheduled periodic transfers of funds
into customers' E*TRADE accounts.
Account Security
The Company uses a combination of proprietary and industry standard security
measures to protect customers' accounts. Customers are assigned unique account
numbers, user identifications and trading passwords that must be used each
time they log on to the system. The Company relies on encryption and
authentication technology, including public key cryptography technology
licensed from RSA Data Security, Inc. ("RSA"), to provide the security and
authentication necessary to effect the secure exchange of information. In
addition the Company uses Secure Socket Layers ("SSL") technology for data
encryption. Touch-tone telephone transactions are secured through a personal
identification number ("PIN")--the same technology used in ATMs. A second
level of password protection is used prior to order placement. In addition,
the Company has an agreement to provide digital certification and
authentication services for electronic commerce through its alliance with
VeriSign, Inc.
Access and Delivery of Services
The Company's services are widely accessible through multiple gateways, with
automated order placement available 24 hours a day, seven days a week by
personal computer. In addition, customers can access E*TRADE by touch-tone
telephone and, in a limited number of markets, through interactive television.
. Personal Computer. Customers using personal computers can access the
E*TRADE system through the Internet, online service providers (America
Online, AT&T WorldNet, CompuServe, Microsoft Network and Prodigy), or
direct modem access. The Company's Web site combines an easy-to-use
graphical user interface with the trading capabilities that experienced
investors demand. The Web-based system also includes direct links to many
investment-related resources on the Web. Alternatively, accessing E*TRADE
by dialing directly through a modem offers a method for connecting to the
trading system independent of either the Internet or a proprietary online
service.
. Touch-tone Telephone. TELE*MASTER, E*TRADE's interactive investing system
provides customers with a convenient way to access quotes, place orders
and access portfolio information using their voice or touch-tone
telephone keypad. E*TRADE is the first online investing service to offer
its customers a fully speech-enabled telephone investing system.
. Interactive Television. GTE MainStreet, an interactive television system
operated by GTE Corporation, is available as a gateway to the Company's
investing services. Revenues and transaction volume through GTE
MainStreet represent an immaterial portion of the Company's business.
Substantially all of the Company's revenues in recent years have been from
online investing services, and the Company expects its online investing
services to continue to account for substantially all of its revenues for the
foreseeable future. E*TRADE, like other investing services firms, is directly
affected by national and international economic and political conditions,
broad trends in business and finance and substantial fluctuations in volume
and price levels of securities and futures transactions. Severe market
fluctuations in the future could have a material adverse effect on the
Company's business, financial condition and operating results. Certain of the
Company's competitors with more diverse product and service offerings may be
better positioned to withstand such a downturn in the securities industry.
5
The market for online investing services, particularly over the Internet, is
at an early stage of development and is rapidly evolving. As is typical for
new and rapidly evolving industries, demand and market acceptance for recently
introduced services and products are subject to a high level of uncertainty.
Sales of many of the Company's services and products will depend upon the
adoption of the Internet by consumers as a widely used medium for commerce and
communication. The Internet may not prove to be a viable commercial
marketplace because of inadequate development of the necessary infrastructure.
Moreover, the security and privacy concerns of existing and potential users of
the Company's services may inhibit the growth of online commerce. If the
necessary infrastructure is not developed, if security and privacy concerns
inhibit the growth of online commerce, or if the Internet does not otherwise
become a viable commercial marketplace, there would be a material adverse
effect on the Company's business, financial condition and operating results.
E*TRADE TRANSACTION-ENABLING TECHNOLOGY
The E*TRADE engine is a proprietary transaction-enabling technology that
automates traditionally labor-intensive transactions. Because it was custom-
tailored for electronic marketplace use, the E*TRADE engine provides customers
with efficient service and has the added advantage of being scalable and
adaptable as usage increases and service offerings are expanded. Beyond these
features, the multi-tiered design of the E*TRADE engine and related software
allows for rapid expansion of network and computing capacity without
interrupting service or requiring replacement of existing hardware or
software.
The E*TRADE Engine
The E*TRADE transaction-enabling technology engine includes a wide variety
of functions and services that allow customers to open and monitor investment
accounts and to place orders for equity and options transactions. E*TRADE's
core technology allows for standardized processing across multiple gateways.
The primary components include a graphical user interface, the interface
server that connects the customer to the processor, and the automated
transaction processor.
. Graphical User Interface ("GUI"). E*TRADE's GUI environment is based on
Netscape's Secure Enterprise Server and today can be accessed by
individuals utilizing Netscape Navigator or Microsoft Internet Explorer.
E*TRADE's GUI connects to the interface server through a bank of Sun
servers. These "gateway servers" provide for load balancing and offer
immediate scalability. Access is restricted through the use of secured
network servers and routers.
. The Interface Server. The interface server's primary function is to
provide access to an efficient, standard transaction processor from all
gateways. The server technology enables communications through multiple
platforms and allows different platforms to communicate with each other.
Beyond these features, the interface server also has been designed to be
scalable and portable and runs in an environment that is both redundant
and secure.
. The Automated Processor. The core of the E*TRADE engine is the automated
processor, designed to provide the highest degree of automation for all
E*TRADE transactions. The automated processor is designed to rapidly read
data, process transactions and transmit information to multiple
locations. Because of this, the Company processes over 85% of its
transactions without any manual intervention. Dual facilities that run
independently share load balancing and provide redundancy and backup, as
well as scalability. The proprietary nature of the system, along with
user ID and password protection at the application level, provide
security for the automated processor. Internet access to the processor is
through the Company's Web site, which restricts access through the use of
secured network servers and routers.
The Company maintains an internal development staff to continually enhance
its software and develop new services and transactions. The Company's software
is designed to be versatile and adaptable so that the E*TRADE engine can be
configured to meet the differing demands of strategic relationships or
customer requests.
6
The Company established a second data center in Rancho Cordova, California,
in July 1996. This facility supports systems, network, trading, customer
service, operations and transaction redundancy and backup between the
Company's Palo Alto and Rancho Cordova data centers, thereby providing
business resumption capability in the event of a service interruption at
either facility. To provide for system continuity during short outages, the
Company also has equipped its computer facilities with uninterruptible power
supply units, as well as backup generators.
The information and financial services and communications industries are
characterized by rapid technological change, changes in customer requirements,
frequent new service and product introductions and enhancements, and emerging
industry standards. The introduction of services or products embodying new
technologies and the emergence of new industry standards and practices can
render existing services or products obsolete and unmarketable. The Company's
future success will depend, in part, on its ability to develop leading
technologies, enhance its existing services and products, develop new services
and products that address the increasingly sophisticated and varied needs of
its prospective customers, and respond to technological advances and emerging
industry standards and practices on a timely and cost-effective basis. There
can be no assurance that the Company will be able, for technical or other
reasons, to develop and introduce new services and products or enhance
existing services and products in a timely manner in response to changing
market conditions or customer requirements, or that new services and products
will achieve market acceptance, the failure of any of which could result in a
material adverse effect on the Company's business, financial condition and
operating results.
A significant risk to online commerce and communication is the insecure
transmission of confidential information over public networks. The Company
relies on encryption and authentication technology, including public key
cryptography technology licensed from RSA, to provide the security and
authentication necessary to effect secure transmission of confidential
information. There can be no assurance that advances in computer capabilities,
new discoveries in the field of cryptography or other events or developments
will not result in a compromise or breach of the RSA or other algorithms used
by the Company to protect customer transaction data. If any such compromise of
the Company's security were to occur, it could have a material adverse effect
on the Company's business, financial condition and operating results.
STRATEGIC RELATIONSHIPS
The Company pursues strategic relationships to increase its access to online
consumers, to build brand-name recognition and to expand the products and
services the Company can provide to its online customers.
Core Business Expansion
E*TRADE has secured or is actively pursuing alliances with (i) Internet
access and service providers, (ii) Internet content providers, (iii) providers
of home and online banking services, and (iv) electronic commerce companies.
These alliances are intended to increase the Company's core customer base,
transaction volume and operational efficiency and to further enhance its
brand-name recognition.
To date, the Company has concentrated principally on securing alliances with
Internet access, online service and content providers. While a majority of the
Company's customers access its services directly through the Internet, direct
modem access or touch-tone telephone, many use online service providers
(America Online, AT&T WorldNet, CompuServe, The Microsoft Network and
Prodigy). Strategic relationships with such service providers allow the
Company to access a greater number of potential customers and allow the online
service providers to offer their subscribers a broader range of service
options. The Company's partnerships with leading content providers fulfill
customers' information needs and help drive transaction volume.
7
New Account Development and Distribution
The Company has developed alliances with key channels in the online medium
to increase account development and expand distribution. These channels
include proprietary online services, internet service providers and popular
destination Web sites such as search engines or financial content providers.
These channels attract significant numbers of users, and the Company's
relationships provide access to expanded market opportunities. Set forth below
are descriptions of certain of the Company's key alliances:
. America Online. America Online, Inc., and the Company have had a business
relationship for over seven years. In October 1996, the Company signed a
nonexclusive agreement with America Online to place E*TRADE in America
Online's new online Brokerage Area, giving America Online's approximately
10 million subscribers access to E*TRADE's Web site.
. AT&T Corp. The Company entered into an agreement with AT&T Corp. which
allows E*TRADE's customers to link directly to the AT&T WorldNet/SM/
Service download site to sign up for the AT&T WorldNet/SM/ Service ((c)1997
AT&T Corp. all rights reserved). AT&T WorldNet/SM/ is a service mark of
AT&T Corp.
. CompuServe. CompuServe Inc., and the Company have had a nonexclusive
contractual relationship for over ten years. Initially, CompuServe served
as an access point for the Company's service bureau business. The
Company's current agreement with CompuServe permits the approximately 5.3
million CompuServe customers to open accounts with E*TRADE and access
those accounts either through CompuServe or any of the Company's other
channels of access.
. Intuit. The Company has entered into a strategic relationship with
Intuit, Inc., to allow customers to download E*TRADE account information
into Quicken 98 for Windows using the Open Financial Exchange (OFX)
communications protocol. In addition, users can directly access E*TRADE's
Web site from Quicken 98 and the Excite Business and Investing channel by
Quicken.com.
. Microsoft. The Company has entered into an alliance with Microsoft
Corporation to integrate E*TRADE's online investing services into the
Microsoft Investor online trading area of The Microsoft Network. E*TRADE
also supports the OFX standard allowing customers to download information
from their E*TRADE account into Microsoft Money 98 and the Microsoft
Investor Portfolio Manager.
. Prodigy Services Corporation. Prodigy Services Corporation, a subsidiary
of Prodigy, Inc., and the Company announced a non-exclusive agreement in
July 1997 to offer Prodigy Internet's members direct access to E*TRADE's
products and services.
. USA Today. The Company has entered into an agreement with USA Today
Information Network to provide direct access to E*TRADE's services
through USA Today Online's Financial Marketplace, a commercial area that
includes personal finance services and products.
. Yahoo! The Company has entered into an agreement with Yahoo! that
provides direct access from the Quotes area of Yahoo! Finance to
E*TRADE's Web site.
. PointCast. The company has entered into an agreement with PointCast, Inc.
to provide PointCast viewers with BASELINE Company Profiles through links
from the PointCast Business Network's Companies Channel to a special
E*TRADE Web site. Additionally, E*TRADE is also featured in PointCast's
Online Trading Center, and the PointCast Portfolio Manager can be
personalized with a button that provides direct access to E*TRADE's Web
site.
. Banc One. Combining the popularity of Internet investing with a full
range of banking services, the Company and BANC ONE CORPORATION,
headquartered in Columbus, Ohio, established co-branded Web sites this
fall to market each other's financial services. In addition, the Company
will take advantage of the opportunity to offer a co-branded credit card
through First USA, the credit card subsidiary of BANC ONE CORPORATION.
. SinaNet. The Company has an exclusive agreement to promote its Internet-
based investing services to Chinese-speaking investors in the United
States through SinaNet, Inc., a media company which has created a popular
Chinese-language web site in North America.
8
In addition, the Company has established relationships with the following:
The Fourth Communication Network, Inc. (a provider of high-speed Internet
access and video services in hotels), Data Broadcasting Corporation (a
provider of financial information to individual investors), Windows on
WallStreet (maker of technical analysis software) and Stockpoint (a provider
of financial information to individual investors).
Content
Content such as news, quotes, charts and fundamental data help provide
investors with the information necessary to make investment decisions. The
Company believes that these information services facilitate new ideas and
increase transaction volume. The Company's partnerships with leading content
providers fulfill customers' information needs and help drive transaction
volume.
. BASELINE Financial Services. BASELINE Financial Services provides
customers with access to a wide array of investment fundamentals, First
Call earnings estimates and historical prices on over 6,500 stocks.
Available to customers free of charge from the "Investor Tools" area of
the E*TRADE Web site, BASELINE information can be used to examine a
company's statistics prior to making investment decisions.
. Briefing.com. Briefing.com, a service of Charter Media, Inc., provides
market commentary and analysis to E*TRADE customers free of charge.
Updates are posted throughout the day to keep investors informed of
important developments affecting the markets.
. INVESTools. The Company has entered into a revenue sharing agreement with
INVESTools that provides E*TRADE customers with direct access to 25
brand-name research reports and newsletters plus stock screening tools on
a pay-per-use basis.
. QUOTE.com. Quote.com. provides current news and charts that are directly
linked to E*TRADE customers' Stock Watch portfolio and quote lookup
features. News provided includes Reuters News, PR Newswire and
BusinessWire. Charts provided include intra-day, daily and weekly price
graphs.
. IDD Enterprises. IDD provides E*TRADE customers with access to mutual
fund profiles and two types of screening tools (Quick Fund Search and
Advanced Fund Search) within the E*TRADE Mutual Fund Center.
. InUnity Corporation. InUnity Corporation provides customers with access
to electronic prospectuses for funds offered within the E*TRADE Mutual
Fund Center.
. Morningstar Inc. Morningstar, Inc., provides performance information and
proprietary "star" ratings on mutual funds within the E*TRADE Mutual Fund
Center.
. MSNBC Business Video. The Company has entered into a revenue sharing
agreement with MSNBC Business Video which provides E*TRADE customers with
direct access to exclusive audio and video coverage of news events
worldwide, as well as an archive of more than 8,000 audio and video
segments at a preferred customer discount.
International
The Company's expansion into new markets is being enhanced by alliances with
companies in key international markets. These alliances enable the Company to
capitalize on these relationships, by providing market knowledge, contacts and
local understanding. The Company believes that these alliances can accelerate
worldwide acceptance of the Company's online investing services.
. Nova Pacific Capital. The Company has formed an alliance with Nova
Pacific Capital Limited, a Sydney, Australia-based financial and
technology development company, to provide online investing to customers
with addresses in Australia and New Zealand under the E*TRADE name.
. VERSUS Technologies, Inc. The Company has entered into an alliance with
VERSUS Technologies, Inc., a Canadian supplier of electronic trading, to
provide online investing services to Canadian residents.
9
Product Enhancement
The Company believes that technology is a key component in maintaining
market leadership in the Internet arena. Partnerships with leading technology
providers support the Company's products and services with up-to-date features
and offer the best solutions for customers.
. National Processing Company. The Company has an agreement with National
Processing Company to provide E*TRADE's customers the ability to initiate
funds transfers from checking accounts at third-party institutions into
their E*TRADE accounts over the Internet. This service is available to
E*TRADE customers free of charge.
. Neural. In February 1997, the Company entered into an agreement with
Neural Applications Corporation ("Neural") that allows Neural's Java-
based intelligent process optimization solutions and data management
systems to be incorporated into the Company's Java-based charting and
quote applications.
. Telesphere. The Company has an agreement with Telesphere Corporation, a
leading global securities information firm, by which Telesphere provides
the Company with real-time market data on some internationally traded
securities, in addition to data on domestically traded securities.
. VeriSign. The Company has entered into an alliance with VeriSign Inc., a
leading provider of digital certification services for electronic
commerce. VeriSign's Digital IDs enhance electronic commerce by
authenticating the individuals, organizations and content involved in an
electronic transaction. Through this alliance, the Company believes that
it will provide its customers with the most technologically advanced
level of security for Internet investing and highly simplified Web site
access.
The Company has established a number of strategic relationships, both
domestic and international, with online and Internet service providers and
software and information service providers. A significant number of such
relationships have only recently been entered into. There can be no assurance
that any such relationships will be maintained, that if such relationships are
maintained, they will be successful or profitable, or that the Company will
develop any new such relationships.
MARKETING
The Company's marketing strategy is based on an integrated marketing model
which employs a mix of communications media. The goals of the Company's
marketing programs are to increase E*TRADE's brand name recognition and to
attract new customers. The Company pursues these goals through advertising,
marketing on its own Web site and other online opportunities, direct one-on-
one marketing, aggressive public relations, and co-marketing programs. All
communications by E*TRADE Securities with the public are regulated by the
National Association of Securities Dealers ("NASD").
Direct Response Advertising; Web Site Marketing
The Company's advertising focuses on building awareness of E*TRADE's brand,
products and services and on marketing online investing as a better way of
handling their securities transactions, accessing financial and market data,
and managing portfolios. Advertising is increasingly directing interested
prospects to the Company's Web site for additional information, as opposed to
generating primarily telephone-based inquiries. Print advertisements are
placed in a broad range of business, technology and financial publications,
including Barron's, Forbes, Forbes ASAP, Investor's Business Daily, Money,
Smart Money, the Wall Street Journal and Wired. E*TRADE also advertises
regularly on financial cable networks, national television networks and on
national business radio networks. Through the Web site, prospective customers
can get detailed information on the Company's services, use an interactive
demonstration system, request additional information and complete an account
application online. Since May 1, 1996, a majority of the Company's new
accounts have been generated through the Internet. E*TRADE's increasing
Internet focus is resulting in decreased customer acquisition costs, since
providing information through its Web site is a more cost effective
alternative to paper-based information packages.
10
Public Relations Program
The Company aggressively pursues public relations opportunities to build
brand awareness. This campaign has resulted in appearances on CNBC, CNN and
The Today Show, in addition to profiles in Barron's, Business Week, the
Financial Times, Investor's Business Daily, Money, Smart Money, Time and the
Wall Street Journal among others. There are links to E*TRADE's Web site from
approximately 1,400 sites on the Web, which the Company believes is a
significant factor in increasing brand awareness and generating leads, as
consumers increasingly look to the Internet as a key source of information and
commercial activity. The Company also actively seeks speaking opportunities at
industry conferences and events.
CUSTOMER SERVICE
The Company believes that providing an effective customer service team to
handle customer needs is critical to its success. The Company's customer
service organization helps customers get online, handles product and service
inquiries and addresses all brokerage and technical questions. The Company's
customers have access to a toll-free number from 5:00 a.m. to 9:00 p.m.
Pacific time, Monday through Friday. The Company's current policy specifies
that customer service associates have or obtain a securities broker's license.
The Company's customer service capacity has been and may continue to be
strained at times. The Company has been making and is continuing to make
significant investments in technology and personnel to improve response times.
The Company's continued focus on customer independence and technology has
successfully resulted in fewer inquiries to E*TRADE personnel per transaction.
However, there can be no assurance that the Company will be able to
consistently provide enough service capacity, particularly during periods of
high market volatility or volume, such as those experienced during October
1997. The failure to provide enough capacity could have a material adverse
effect on the Company's business, financial condition and operating results.
OPERATIONS
Clearing
The Company implemented equities self-clearing operations in July 1996 and
options self-clearing operations in April 1997. Clearing operations include
the confirmation, receipt, settlement, custody and delivery functions involved
in securities transactions. Performing its own clearing operations allows
E*TRADE Securities to retain customer free credit balances and securities for
use in margin lending activities subject to Securities and Exchange Commission
("SEC") and NASD rules. The Company has a seven-year agreement with Beta
Systems for the provision of computer services by Beta Systems to support
order entry, order routing, securities processing, customer statements, tax
reporting, regulatory reporting, and other services necessary to the
management of a brokerage clearing business.
Since the Company's conversion to self-clearing, customers' securities
typically are held by the Company in nominee name on deposit at one or more of
the recognized securities industry depository trust companies, to facilitate
ready transferability. The Company collects dividends and interest on
securities held in nominee name and makes the appropriate credits to customer
accounts. The Company also facilitates exercise of subscription rights on
securities held for its customers. The Company arranges for the transmittal of
proxy, annual report and tender offer materials to customers. E*TRADE
Securities relies upon certificate counts and microfilming procedures as
deterrents to theft of securities and, as required by the NASD and certain
other regulatory authorities, carries fidelity bonds covering loss or theft.
Self-clearing, especially where conducted by firms such as the Company without
significant prior experience, involves substantial risks. The failure of the
Company to perform self-clearing accurately and cost-effectively could have a
material adverse effect on the Company's business, financial condition and
operating results.
11
Lending and Borrowing Activities
Margin Lending. The Company makes loans to customers collateralized by
customer securities. Margin lending by the Company is subject to the margin
rules of the Board of Governors of the Federal Reserve System, NASD margin
requirements and the Company's internal policies, which are more stringent
than the Federal Reserve and NASD requirements. In permitting customers to
purchase securities on margin, the Company takes the risk of a market decline
that could reduce the value of the collateral held by the Company to below the
customers' indebtedness before the collateral can be sold, which could result
in losses to the Company. Under applicable NASD rules, in the event of a
decline in the market value of the securities in a margin account, the Company
is obligated to require the customer to deposit additional securities or cash
in the account so that at all times the customer's equity in the account is at
least 25% of the value of the securities in the account. E*TRADE's current
internal requirement, however, is that the customer's equity not fall below
30%. If it does, the customer will be required to increase the account's
equity to 35%. Margin lending to customers constitutes the major portion of
the basis on which net capital requirements of the Company are determined
under the SEC's Net Capital Rule. To the extent these activities expand, the
Company's net capital requirements will increase.
Securities Lending and Borrowing. The Company borrows securities both to
cover short sales and to complete customer transactions in the event a
customer fails to deliver securities by the required settlement date. The
Company collateralizes such borrowings by depositing cash or securities with
the lender and receives a rebate (in the case of cash collateral) or pays a
fee calculated to yield a negotiated rate of return. When lending securities,
the Company receives cash or securities and generally pays a rebate (in the
case of cash collateral) to the other party in the transaction. Securities
lending and borrowing transactions are executed pursuant to written agreements
with counterparties that require that the securities borrowed be marked to
market on a daily basis and that excess collateral be refunded or that
additional collateral be furnished in the event of changes in the market value
of the securities. The securities usually are marked to market on a daily
basis through the facilities of the various national clearing organizations.
Order Processing
All listed market orders other than those with special qualifiers (subject
to certain size limitations based on the size in the primary market) are
executed at the National Best Bid/Offer ("NBBO") or better at the time of
receipt by the third market firm or exchange. Eligible orders are exposed to
the marketplace for possible price improvement, but in no case are orders
executed at a price inferior to the NBBO. Limit orders are executed based on
an indicated price and time priority. All Nasdaq market orders (subject to
certain size limitations based on the trading characteristics of the
particular security) are executed at the Best Bid/Offer (Inside Market), or
better at the time of receipt by the market maker. Eligible orders are subject
to possible price improvement in the marketplace.
The Company receives orders principally through the Internet, online
services and touch-tone telephone. This method of trading is heavily dependent
on the integrity of the electronic systems supporting it. Orders placed from
the close of the stock markets one day until the opening the next business day
must be processed through the Company's system prior to the opening of the
stock markets. Heavy stress placed on the Company's systems during peak
trading times could cause the Company's systems to operate at unacceptably low
speeds or fail altogether. Any significant degradation or failure of the
Company's systems or any other systems in the trading process (e.g., online
service providers, recordkeeping and data processing functions performed by
third parties or third-party software such as Internet browsers), even for a
short time, could cause customers to suffer delays in trading. Such delays
could cause substantial losses for customers and could subject the Company to
claims from customers for such losses, including litigation claiming fraud or
negligence.
The Company has experienced such system failures and degradation in the past
and could experience future system failures and degradation. In order to
promote customer satisfaction and protect the E*TRADE brand name, the Company
has compensated customers for verifiable losses arising in connection with
such
12
failures. During a systems failure, the Company may be able to take orders by
telephone. However, under applicable regulations, all Company associates
accepting telephone orders must have a securities broker's license. An
adequate number of personnel with securities brokers licenses may not be
available to take customers calls in the event of a systems failure. There can
be no assurance that the Company's network structure will operate
appropriately in the event of a subsystem, component or software failure or
that, in the event of an earthquake, fire or any other natural disaster, power
or telecommunications failure, act of God or act of war, the Company will be
able to prevent an extended systems failure. Any systems failure that causes
interruptions in the Company's operations could have a material adverse effect
on the Company's business, financial condition and operating results. In
addition, the Company has, from time to time, received adverse publicity in
the financial press and in online discussion forums primarily relating to
perceived systems degradations. On November 21, 1997, a putative class action
complaint was filed claiming damages and injunctive relief due to alleged
false and misleading advertising regarding the Company's commission rates and
the Company's ability to execute transactions in a timely manner. See Item 3,
"Legal Proceedings."
The Company relies on a number of third parties to process its transactions,
including online and Internet service providers, back office processing
organizations, and market makers, all of which may need to expand the scope of
the operations they perform for the Company. Any backlog caused by a third
party's inability to expand at the rate necessary to meet the Company's needs
or a loss in the availability of these services and the inability of the
Company to make alternative arrangements in a timely manner, if at all, could
have a material adverse effect on the Company's business, financial condition
and operating results.
COMPETITION
The market for online investing services, particularly over the Internet, is
new, rapidly evolving and intensely competitive, and the Company expects
competition to continue to intensify in the future. E*TRADE encounters direct
competition from discount brokerage firms providing either touch-tone
telephone or online investing services, or both. These competitors include
Charles Schwab & Co., Inc. ("Charles Schwab") and Fidelity Brokerage Services,
Inc., among others. The Company also encounters competition from established
full-commission brokerage firms, such as Merrill Lynch, Pierce, Fenner & Smith
Incorporated and PaineWebber Incorporated, among others. In addition, the
Company competes with financial institutions, mutual fund sponsors and other
organizations, some of which provide online investing services.
The Company believes that the principal competitive factors affecting the
market for its transaction-enabling services are service, quality, execution,
delivery platform capabilities, ease of use, graphical user interface look and
feel, depth and breadth of services and content, cost, financial strength and
innovation. Based on research conducted with both customer and non-customer
focus groups and the success the Company has enjoyed, the Company believes
that it presently competes favorably with respect to each of these factors.
Many of the Company's competitors have longer operating histories and
significantly greater financial, technical, marketing and other resources than
the Company. Many current and potential competitors also have greater name
recognition and more extensive customer bases that could be leveraged, thereby
gaining market share to the Company's detriment. Such competitors may be able
to undertake more extensive promotional activities, offer more attractive
terms to customers than the Company and adopt more aggressive pricing
policies, possibly even sparking a price war in the electronic brokerage
business. Moreover, current and potential competitors have established or may
establish cooperative relationships among themselves or with third parties to
enhance their services and products. Additionally, it is possible that new
competitors or alliances among competitors may emerge and rapidly acquire
significant market share.
The general financial success of companies within the securities industry
over the past several years has strengthened existing competitors. The
Company's management believes that such success will continue to attract new
competitors to the securities industry, such as banks, software development
companies, insurance companies, providers of online financial and information
services and others, as such companies expand their
13
product lines. The current trend toward consolidation in the commercial
banking industry could further increase competition in all aspects of the
Company's business. While it is not possible to predict the type and extent of
competitive services that commercial banks and other financial institutions
ultimately may offer or whether administrative or legislative barriers will be
repealed or modified, firms such as the Company may be adversely affected by
such competition or legislation. In addition, competition among financial
services firms exists for experienced technical and other personnel.
There can be no assurance that the Company will be able to compete
effectively with current or future competitors or that the competitive
pressures faced by the Company will not have a material adverse effect on the
Company's business, financial condition and operating results.
INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS
The Company's success and ability to compete are dependent to a significant
degree on its proprietary technology. The Company relies primarily on
copyright, trade secret and trademark law to protect its technology. The
Company has no patents. Effective trademark protection may not be available
for the Company's trademarks. The Company has registered the trademark
"E*TRADE" in the United States and certain other countries, and has certain
other registered trademarks. The inability of the Company to adequately
protect the name "E*TRADE" would have a material adverse effect on the
Company's business, financial condition and operating results.
The source code for the Company's proprietary software is protected both as
a trade secret and as a copyrighted work. The Company's policy is to enter
into confidentiality and assignment agreements with its associates,
consultants and vendors and generally to control access to, and distribution
of, its software, documentation and other proprietary information.
Notwithstanding the precautions taken by the Company, it may be possible for a
third party to copy or otherwise obtain and use the Company's software or
other proprietary information without authorization or to develop similar
software independently. The laws of other countries may afford the Company
little or no effective protection of its intellectual property. The inability
of the Company to protect its intellectual property rights could have a
material adverse effect on the Company's business, financial condition and
operating results.
The Company may in the future receive notices of claims of infringement of
other parties' proprietary rights. Any such claims, with or without merit,
could be time-consuming to defend, result in costly litigation, divert
management's attention and resources or require the Company to enter into
royalty or licensing agreements. There can be no assurance that such licenses
would be available on reasonable terms, if at all, and the assertion or
prosecution of any such claims could have a material adverse effect on the
Company's business, financial condition and operating results.
GOVERNMENT REGULATION; NET CAPITAL REQUIREMENTS
Securities Industry
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. The SEC is the federal agency
responsible for the administration of the federal securities laws. E*TRADE
Securities is registered as a broker-dealer with the SEC. Much of the
regulation of broker-dealers has been delegated to self-regulatory
organizations, principally the NASD, which has been designated by the SEC as
E*TRADE Securities' primary regulator. These self-regulatory organizations
adopt rules (subject to approval by the SEC) that govern the industry, and
conduct periodic examinations of E*TRADE Securities' operations. Securities
firms are also subject to regulation by state securities administrators in
those states in which they conduct business. E*TRADE Securities is registered
as a broker-dealer in all 50 states and the District of Columbia.
14
The Company is aware of several instances of its noncompliance with
applicable regulations. In particular, the Company failed to comply with
applicable advertising restrictions in one international jurisdiction, and due
to a clerical oversight, failed to renew its registration as a broker-dealer
in two states; Nebraska and Ohio. One of the states, Ohio, as a condition of
renewing the Company's license as a broker-dealer in that state, required the
Company to offer customers resident in that state the ability to rescind (for
up to 30 days) certain securities transactions effected through the Company
during the period January 1, 1997 through April 15, 1997, the date the
Company's license was renewed. For fiscal 1997, the Company recorded a one-
time $4.3 million pre-tax charge against earnings in connection with this
matter.
Broker-dealers are subject to regulations covering all aspects of the
securities business, including sales methods, trade practices among broker-
dealers, use and safekeeping of customers' funds and securities, capital
structure, recordkeeping and the conduct of directors, officers and employees.
The Company is required to comply with many complex laws and rules, including
rules relating to possession and control of customer funds and securities,
margin lending and execution and settlement of transactions. Additional
legislation, changes in rules promulgated by the SEC, the NASD, the Board of
Governors of the Federal Reserve System, the various stock exchanges, and
other self-regulatory organizations, or changes in the interpretation or
enforcement of existing laws and rules, may directly affect the mode of
operation and profitability of broker-dealers. The SEC, the NASD or other
self-regulatory organizations and state securities commissions may conduct
administrative proceedings, which can result in censure, fine, the issuance of
cease-and-desist orders or the suspension or expulsion of a broker-dealer or
any of its officers or employees. The Company's ability to comply with all
applicable laws and rules is dependent in large part on the maintenance of a
control system reasonably designed to ensure such compliance. The principal
purpose of regulation and discipline of broker-dealers is the protection of
customers and the securities markets, rather than protection of creditors and
stockholders of broker-dealers. In addition, because the use of the Internet
to provide online investing services is relatively new, regulatory standards
are evolving. As a result, the Company may, in the future, become subject to
additional regulation in the United States and in international jurisdictions.
E*TRADE Securities is a member of Securities Investor Protection Corporation
("SIPC"), which provides, in the event of the liquidation of a broker-dealer,
protection for customers' accounts held by E*TRADE Securities of up to
$500,000 for each customer account, subject to a limitation of $100,000 for
claims for cash balances. In addition, E*TRADE Securities has obtained
protection, in excess of SIPC coverage, of $9.5 million for each account in
the form of an excess securities bond from National Union Fire Insurance
Company of Pittsburgh, Pennsylvania, a member company of American
International Group.
The Company has initiated an aggressive marketing campaign designed to bring
brand-name recognition to E*TRADE. All marketing activities by E*TRADE
Securities are regulated by the NASD, and all such marketing materials are
required by the NASD to be reviewed by E*TRADE Securities' compliance officer
prior to release. The Company does not currently solicit orders from its
customers or make investment recommendations. However, if the Company were to
engage in such activities, it would become subject to additional rules and
regulations governing, among other things, the suitability of recommendations
to customers and sales practices.
It is the Company's intent to expand its business to other countries through
the Internet and other gateways. In order to expand its services globally,
E*TRADE Securities must comply with the regulatory controls of each specific
country in which it conducts business. E*TRADE Securities is regulated in the
United States primarily by the NASD and the SEC. The varying compliance
requirements of other national regulatory jurisdictions may impose a limit to
the Company's rate of international expansion.
Net Capital Requirements
As registered broker-dealers and members of the NASD, E*TRADE Securities and
E*TRADE Capital (a non-operational broker-dealer subsidiary of the Company)
are subject to the Uniform Net Capital Rule (the "Rule"). The Rule, which
specifies the minimum net capital requirements for registered broker-dealers,
is designed to measure the general financial integrity and liquidity of a
broker-dealer and requires that at least a minimum part of its assets be kept
in relatively liquid form.
15
E*TRADE Securities has elected to compute net capital under the alternative
method of calculation permitted by the Rule. Under the alternative method,
E*TRADE Securities is required to maintain minimum net capital, as defined in
the Rule, equal to the greater of $250,000 or 2% of the amount of its
"aggregate debit items" computed in accordance with the Formula for
Determination of Reserve Requirements for Brokers and Dealers. The "aggregate
debit items" are assets that have, as their source, transactions with
customers, primarily margin loans. Failure to maintain the required net
capital may subject a firm to suspension or revocation of registration by the
SEC and suspension or expulsion by the NASD and other regulatory bodies and
ultimately could require a firm's liquidation. The Rule prohibits payments of
dividends, redemption of stock, the prepayment of subordinated indebtedness,
and the making of any unsecured advance or loan to a stockholder, employee or
affiliate, if aggregate debit items rise beyond 5% of net capital. The Rule
also provides that the SEC may restrict, for up to 20 business days, any
withdrawal of equity capital, or unsecured loans or advances to stockholders,
employees or affiliates ("capital withdrawal"), if such capital withdrawal,
together with all other net capital withdrawals during a 30-day period,
exceeds 30% of excess net capital and the SEC concludes that the capital
withdrawal may be detrimental to the financial integrity of the broker-dealer.
Net capital is essentially defined as net worth (assets minus liabilities),
plus qualifying subordinated borrowings and certain discretionary liabilities,
less certain mandatory deductions that result from excluding assets that are
not readily convertible into cash and from valuing conservatively certain
other assets. Among these deductions are adjustments (called "haircuts") which
reflect the possibility of a decline in the market value of an asset prior to
its disposition.
A change in the Rule, the imposition of new rules or any unusually large
charge against net capital could limit those operations of the Company that
require the intensive use of capital, such as trading activities and the
financing of customer account balances, and also could restrict the Company's
ability to withdraw capital from its brokerage subsidiaries, which in turn
could limit the Company's ability to pay dividends, repay debt and redeem or
purchase shares of its outstanding stock.
As of September 30, 1997, E*TRADE Securities was required to maintain
minimum net capital of $13.8 million and had total net capital of
approximately $51.7 million, or approximately $37.9 million in excess of the
minimum amount required. In February 1996, E*TRADE Capital, then doing
business as ET Execution Services, fell short of its minimum net capital
requirement and thus was in violation of the Rule. The Company reported the
violation of E*TRADE Capital to the SEC and the NASD and has implemented
internal controls intended to prevent such violations in the future. There can
be no assurance that such a violation of the Rule will not occur in the
future.
Electronic Commerce
The Company anticipates that it may be required to comply with
recordkeeping, data processing and other regulatory requirements as a result
of proposed federal legislation or otherwise, and the Company may be subject
to additional regulation as the market for online commerce evolves. Because of
the growth in the electronic commerce market, Congress has held hearings on
whether to regulate providers of services and transactions in the electronic
commerce market, and federal or state authorities could enact laws, rules or
regulations affecting the Company's business or operations. The Company also
may be subject to federal, state and foreign money transmitter laws and state
and foreign sales and use tax laws. If enacted or deemed applicable to the
Company, such laws, rules or regulations could be imposed on the Company's
activities or its business.
Due to the increasing popularity of the Internet, it is possible that laws
and regulations may be enacted with respect to the Internet, covering issues
such as user privacy, pricing, content and quality of products and services.
The Telecommunications Act of 1996 prohibits the transmission over the
Internet of certain types of information and content. Although certain of
these prohibitions have been held unconstitutional, the increased attention
focused upon these liability issues as a result of the Telecommunications Act
could adversely affect the growth of Internet and private network use.
16
ASSOCIATES
At September 30, 1997, the Company had 499 associates. The Company's success
has been, and will be, dependent to a large degree on its ability to retain
the services of its existing executive officers and to attract and retain
qualified additional senior and middle managers and key personnel in the
future. There can be no assurance that the Company will be able to attract,
assimilate or retain qualified technical and managerial personnel in the
future, and the failure of the Company to do so would have a material adverse
effect on the Company's business, financial condition and operating results.
None of the Company's associates is subject to collective bargaining
agreements or is represented by a union. The Company considers its relations
with its associates to be good.
EXECUTIVE OFFICERS OF THE REGISTRANT
In addition to the executive officers who are also directors of the Company,
the following executive officers are not directors and are elected by and
serve at the discretion of the Board of Directors:
NAME AGE POSITION
---- --- --------
Judy Balint........................... 44 Senior Vice President, Global
Marketing and Strategic Business
Development
Debra Chrapaty........................ 36 Senior Vice President, E*TRADE
Technologies and Chief Information
Officer
Kathy Levinson........................ 42 Executive Vice President, Customer
Operations; President and Chief
Operating Officer of E*TRADE
Securities, Inc.
Rebecca L. Patton..................... 42 Senior Vice President, Advanced
Products Group
Stephen C. Richards................... 43 Chief Financial Officer and
Treasurer; Senior Vice President,
Finance and Administration; Chief
Financial Officer of E*TRADE
Securities, Inc.
Judy Balint is Senior Vice President, Global Marketing and Strategic
Business Development of the Company. Prior to joining E*TRADE in March 1997,
Ms. Balint was Senior Vice President and corporate director of marketing for
National Processing Company, consultants in transaction technology, from
February 1996 to March 1997. Ms. Balint served as CEO Paris and Managing
Director of CME--KHBB Transactional Advertising, a global advertising network
of the former Saatchi & Saatchi Group, from 1992 to April 1995. Ms. Balint
held a variety of positions with Federal Express Corporation from 1987 to 1992
and with DHL Worldwide Express from 1979 to 1987. Ms. Balint received a BA in
journalism from the University of Wisconsin, Madison, and an MBA in
international business from the Monterey Institute of International Studies.
Debra Chrapaty is Senior Vice President, E*TRADE Technologies, and Chief
Information Officer of the Company. Prior to joining the Company in July 1997,
Ms. Chrapaty served as vice president and chief technology officer for the
National Basketball Association ("NBA") from 1994 through June 1997. Before
joining the NBA, from 1992 through 1994 Ms. Chrapaty was Director, Internal
Systems Consulting, at Bertelsmann C.I.S. in New York. From 1990 through 1992,
she was with EMI Records Group in New York. Her previous experience with
financial organizations includes stints with the Federal Reserve Bank of New
York from 1985 to 1990 and Chase Econometrics/IDC in Philadelphia. Ms.
Chrapaty received a BBA in economics from Temple University and an MBA in
information systems from New York University.
Kathy Levinson has served as Executive Vice President of the Company since
November 1996 and President and Chief Operating Officer of E*TRADE Securities,
Inc., since January 1996, and a director of E*TRADE Securities, Inc. since
June 1996. From January 1995 to December 1995, Ms. Levinson worked as a
consultant for the Company. Prior to that, Ms. Levinson worked for Charles
Schwab from 1981 to 1994, most recently serving as Senior Vice President of
Custody Services and prior to that, was Senior Vice President of Credit
Service from 1989 to October 1994. She received a BA in economics from
Stanford University.
17
Rebecca L. Patton has served as Senior Vice President, Advanced Products
Group since July 1997. Ms. Patton joined the Company in September 1995 as Vice
President, Marketing and served as Senior Vice President, Marketing and
Communications from August 1996 to July 1997. From 1988 to September 1995, Ms.
Patton served in a variety of management positions at Apple Computer,
including Worldwide Marketing Manager of the Personal Interactive Electronics
Division and Manager of Apple's PowerBook Marketing Group. Ms. Patton received
a BA in economics, from Duke University and an MBA from Stanford University.
Stephen C. Richards joined the Company in April 1996 as Chief Financial
Officer and Treasurer and has served as Senior Vice President, Finance and
Administration and Chief Financial Officer of E*TRADE Securities, Inc. since
June 1996. From 1984 to April 1996, Mr. Richards served in various positions
at Bear Stearns & Co., Inc., an investment bank, including Managing Director
and Chief Financial Officer of Correspondent Clearing. Prior to 1984, Mr.
Richards served as Vice President/Deputy Controller of Becker Paribas and
First Vice President/Controller of Jefferies & Company, Inc. He received a BA
in statistics and economics from the University of California at Davis and an
MBA in finance from the University of California at Los Angeles. Mr. Richards
is a certified public accountant.
The Company's present directors and executive officers and their respective
affiliates beneficially own approximately 19.5% of the outstanding Common
Stock. As a result, these stockholders, if they act together, will be able to
exercise significant influence over all matters requiring stockholder
approval, including the election of directors and approval of significant
corporate transactions. Such concentration of ownership also may have the
effect of delaying, preventing or deterring a change in control of the
Company.
ITEM 2. PROPERTIES
The Company currently leases three spaces for its corporate offices in Palo
Alto, California. The leases comprise an aggregate of 75,000 square feet and
expire beginning in June 2000. The Company established a second data center in
Rancho Cordova, California, in July 1996. The Company leases an aggregate
72,000 square feet at the Rancho Cordova facility. The lease expires in June
2006. The Company believes that it has adequate space for its current needs.
ITEM 3. LEGAL PROCEEDINGS
On November 21, 1997, a putative class action complaint was filed in the
Superior Court of California, County of Santa Clara, by Larry R. Cooper on
behalf of himself and other similarly situated individuals. The complaint
alleges, among other things, that the Company's advertising, other
communications and business practices regarding the Company's commissions
rates and its ability to timely execute transactions through its online
brokerage services were false and deceptive. The complaint seeks injunctive
relief enjoining the purported deceptive and unfair practices alleged in the
complaint and also seeks unqualified compensatory and punitive damages.
This proceeding is at a very early stage and the Company is unable to
speculate as to its ultimate outcome. However, the Company believes it has
meritorious defenses to the claims and intends to conduct vigorous defenses.
Furthermore, the Company believes that all or a part of any damages which the
Company may incur, including legal costs, may be covered under its insurance
policies. An unfavorable outcome in any matters which are not covered by
insurance, however, could have a material adverse effect on the Company's
business, financial condition and results of operations. In addition, even if
the ultimate outcomes are resolved in favor of the Company, the defense of
such litigation could entail considerable cost and the diversion of efforts of
management, either of which could have a material adverse effect in the
Company's results of operation.
From time to time the Company has been threatened with, or named as a
defendant in, lawsuits and administrative claims. Compliance and trading
problems that are reported to the NASD or the SEC by dissatisfied customers
are investigated by the NASD or the SEC, and, if pursued by such customers,
may rise to the level of arbitration or disciplinary action. One or more of
such claims or disciplinary actions decided adversely to the Company could
have a material adverse effect on the Company's business, financial condition
and results of operations. The Company is also subject to periodic regulatory
audits and inspections.
18
The securities industry is subject to extensive regulation under federal,
state and applicable international laws. As a result, the Company is required
to comply with many complex laws and rules and its ability to so comply is
dependent in large part on the establishment and maintenance of a qualified
compliance system. The Company is aware of several instances of its
noncompliance with applicable regulations. In particular, in fiscal 1997, the
Company failed to comply with applicable advertising restrictions in one
international jurisdiction, and due to a clerical oversight failed to timely
renew its registration as a broker-dealer in two states; Nebraska and Ohio.
One of the state jurisdictions, Ohio, as a condition of renewing the Company's
license as a broker-dealer in that jurisdiction, required the Company to offer
customers resident in that state the ability to rescind (for up to 30 days)
certain securities transactions effected through the Company during the period
January 1, 1997 through April 15, 1997, the date the Company's license was
renewed. For fiscal 1997, the Company recorded a one-time $4.3 million pre-tax
charge against earnings in connection with this matter.
The Company maintains insurance in such amounts and with such coverages,
deductibles and policy limits as management believes are reasonable and
prudent. The principal risks that the Company insures against are
comprehensive general liability, commercial property, hardware/software
damage, directors and officers, errors and omissions liability. The Company
believes that such insurance coverages are adequate for the purpose of its
business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
PRICE RANGE OF COMMON STOCK
The Company's Common Stock has been traded on the Nasdaq National Market
under the symbol EGRP since the Company's initial public offering on August
16, 1996. The following table shows the high and low sale prices of the
Company's Common Stock as reported by the Nasdaq National Market for the
periods indicated.
HIGH LOW
------ ------
FISCAL 1996
Fourth Quarter (from August 16, 1996)...................... $13.19 $ 8.38
FISCAL 1997
First Quarter.............................................. $12.50 $ 9.00
Second Quarter............................................. $25.25 $11.13
Third Quarter.............................................. $21.00 $14.75
Fourth Quarter............................................. $47.00 $17.97
The closing sale price of the Company's Common Stock as reported on the
Nasdaq National Market on December 12, 1997 was $22.38 per share. As of that
date there were 249 holders of record of the Company's Common Stock.
The market price of the Company's Common Stock is likely to be highly
volatile and could be subject to wide fluctuations in response to quarterly
variations in operating results, announcements of technological innovations or
new software, services or products by the Company or its competitors, changes
in financial estimates by securities analysts or other events or factors, many
of which are beyond the Company's control. In addition, the stock market has
experienced significant price and volume fluctuations that have particularly
19
affected the market prices of equity securities of many technology, internet
and services companies and that often have been unrelated to the operating
performance of such companies. These broad market fluctuations may adversely
affect the market price of the Company's Common Stock. In the past, following
periods of volatility in the market price for a company's securities,
securities class action litigation sometimes has been instituted. Such
litigation could result in substantial costs and a diversion of management
attention and resources, which could have a material adverse effect on the
Company's business, financial condition and operating results.
DIVIDENDS
The Company has never declared or paid cash dividends on its capital stock.
The Company currently intends to retain all of its earnings, if any, for use
in its business and does not anticipate paying any cash dividends in the
foreseeable future. The payment of any future dividends will be at the
discretion of the Company's Board of Directors and will depend on a number of
factors, including future earnings, the success of the Company's business
activities, regulatory capital requirements, the general financial condition
and future prospects of the Company, general business conditions and such
other factors as the Board of Directors may deem relevant.
USE OF PROCEEDS
On August 16, 1996, a Registration Statement on Form S-1 (No. 333-05525) was
declared effective by the Securities and Exchange Commission, pursuant to
which 5,026,550 shares of the Company's Common Stock were offered and sold for
the account of the Company at a price of $10.50 per share, generating gross
offering proceeds of $52,779,000 for the account of the Company. A further
675,450 shares of the Company's Common Stock were offered and sold for the
account of selling stockholders at a price of $10.50 per share, generating
gross offering proceeds of $7,092,000 for the account of selling stockholders.
Each share of Series A, Series B and Series C Preferred Stock was
automatically converted into 60 shares of Common Stock upon the closing of the
initial public offering. The managing underwriters were BancAmerica Robertson
Stephens, Hambrecht & Quist LLC, and Deutsche Morgan Grenfell/C.J. Lawrence,
Inc.
In connection with the offering, the Company incurred $3,695,000 in
underwriting discounts and commissions, and $2,682,000 in other related
expenses. The net proceeds of the offering, after deducting the foregoing
expenses, were $46,402,000.
On August 20, 1997, a Registration Statement on Form S-1 (No. 333-31841) was
declared effective by the Securities and Exchange Commission, pursuant to
which 7,305,000 shares of the Company's Common Stock were offered and sold for
the account of the Company at a price of $27.50 per share, generating gross
offering proceeds of $200,888,000 for the account of the Company. A further
2,010,000 shares of the Company's Common Stock were offered and sold for the
account of selling stockholders at a price of $27.50 per share, generating
gross offering proceeds of $55,275,000 for the account of selling
stockholders. The managing underwriters were BancAmerica Robertson Stephens,
Hambrecht & Quist LLC, Deutsche Morgan Grenfell/C.J. Lawrence, Inc.,
NationsBanc Montgomery Securities, and E*TRADE Securities, Inc.
In connection with the offering, the Company incurred $10,044,000 in
underwriting discounts and commissions, and $2,019,000 in other related
expenses. The net proceeds of the offering, after deducting the foregoing
expenses, were $188,825,000.
The Company has used a portion of the net proceeds of the two offerings as
follows: (i) $10,655,000 for the purchase and installation of software,
machinery and equipment, (ii) $2,665,000 for the construction of plant,
building and facilities, (iii) $2,250,000 for the repayment of indebtedness,
(iv) $3,147,000 for a relocation loan to an officer, (v) $1,793,000 for
additional investment in Roundtable Partners LLC, (vi) $2,000,000 for
investment in KAP Group, LLC, (vii) $2,832,000 for investment in new projects,
technology and products to expand and complement the business, and (viii)
$209,885,000 for investment in short-term, investment grade, interest bearing
securities.
20
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
YEARS ENDED SEPTEMBER 30,
----------------------------------------
1997 1996 1995 1994 1993
-------- ------- ------- ------ ------
(in thousands, except per share amounts)
CONSOLIDATED STATEMENT OF OPERATIONS
DATA:
Revenues:
Transaction revenues................ $109,659 $44,178 $20,835 $9,548 $2,158
Interest, net of interest expense... 25,265 4,813 1,004 302 17
International....................... 4,000 -- -- -- --
Computer services and other......... 3,813 2,604 1,501 1,055 799
-------- ------- ------- ------ ------
Net revenues....................... 142,737 51,595 23,340 10,905 2,974
-------- ------- ------- ------ ------
Cost of services:
Cost of services.................... 66,507 34,268 13,340 7,646 1,973
Registration charge................. 4,334 -- -- -- --
Self-clearing start-up costs........ -- 2,240 141 -- --
-------- ------- ------- ------ ------
Total cost of services............. 70,841 36,508 13,481 7,646 1,973
-------- ------- ------- ------ ------
Operating expenses:
Selling and marketing............... 24,193 7,600 2,466 998 282
Technology development.............. 10,761 2,792 943 335 216
General and administrative.......... 13,612 6,078 2,141 1,682 400
-------- ------- ------- ------ ------
Total operating expenses........... 48,566 16,470 5,550 3,015 898
-------- ------- ------- ------ ------
Total cost of services and operat-
ing expenses 119,407 52,978 19,031 10,661 2,871
-------- ------- ------- ------ ------
Pre-tax income (loss)................ 23,330 (1,383) 4,309 244 103
Income tax expense (benefit)......... 9,425 (555) 1,728 (541) 4
-------- ------- ------- ------ ------
Net income (loss).................... $ 13,905 $ (828) $ 2,581 $ 785 $ 99
======== ======= ======= ====== ======
Net income (loss) per share.......... $ 0.40 $ (0.03) $ 0.10 $ 0.03 $ --
======== ======= ======= ====== ======
Weighted average number of common and
common equivalent shares outstand-
ing................................. 34,574 28,564 26,481 26,186 26,677
======== ======= ======= ====== ======
SEPTEMBER 30,
----------------------------------------
1997 1996 1995 1994 1993
-------- ------- ------- ------ ------
(in thousands)
CONSOLIDATED BALANCE SHEET DATA:
Cash and equivalents................. $ 21,814 $14,641 $ 9,624 $ 692 $ 36
Total assets......................... 989,903 294,881 14,164 2,163 728
Long-term obligations................ -- -- 45 64 1,310
Stockholders' equity (deficiency).... 281,275 69,304 11,148 (92) (788)
21
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the consolidated
financial statements and notes thereto included elsewhere in this Form 10-K.
This discussion contains forward-looking statements which involve risks and
uncertainties. The Company's actual results may differ materially from those
anticipated in these forward-looking statements as a result of certain
factors, including, but not limited to, those set forth elsewhere in this Form
10-K.
OVERVIEW
E*TRADE is a leading provider of online investing services and has
established a popular, branded destination Web site for self-directed
investors. Founded in 1982, the Company operated initially as a service
bureau, providing automated online securities transaction services to various
brokerage firms, including Fidelity Brokerage Services, Inc., Quick & Reilly,
Inc., and, through an agreement with Bank of America, Charles Schwab. In 1992,
the Company formed E*TRADE Securities and began to offer retail investing
services and account information 24 hours a day, seven days a week.
The Company's revenues consist principally of transaction revenues, which
include securities brokerage commissions and payments based on order flow
(described below), interest and certain other fees related to the Company's
product offerings. The Company has experienced substantial growth in its
revenues since the inception of E*TRADE Securities. At the end of fiscal 1992,
the Company was processing slightly over 100 transactions per day. For
September 1997, the Company's average daily transaction volume had grown to
25,600. Although increases in the overall activity in the securities markets
have contributed to the Company's growth, the Company believes that its growth
has also been due to the success of its advertising campaigns in bringing
brand name recognition to the E*TRADE name, the launch of Internet access to
E*TRADE and the continuing successful integration of new product developments.
The Company uses other broker-dealers to execute its customers' orders and,
in recent years, has derived a significant portion of its revenues from these
broker-dealers for such order flow. This practice of receiving payments for
order flow is widespread in the securities industry. Under applicable SEC
regulations, receipt of these payments requires disclosure of such payments by
the Company to its customers. The revenues received by the Company under these
arrangements for fiscal 1997, 1996 and 1995 amounted to 19%, 22% and 20% of
net revenues, respectively. However, the amount received per transaction has
declined over these periods, and the Company expects this trend to continue.
There can be no assurance that these revenues will continue at their present
levels or that the Company will be able to continue its present relationships
and terms for such payments for order flow. In addition, there can be no
assurance that payments for order flow will continue to be permitted by the
SEC, the NASD or other regulatory agencies, courts or governmental units. Loss
of any or all of these revenues could have a material adverse effect on the
Company's business, financial condition and operating results.
The Company is making significant investments in systems technology and has
established a second data center in Rancho Cordova, California, in July 1996.
This facility supports systems, network services, trading, customer service,
transaction redundancy and backup between the Company's Palo Alto and Rancho
Cordova locations, thereby providing an operational system in the event of a
service interruption at either facility.
The Company has and will continue to make certain investments in its
software systems and applications to ensure the Company is year 2000
compliant. The financial impact to the Company has not been and is not
anticipated to be material to its financial position or results of operations
in any given year.
The Company implemented equities self-clearing operations in July 1996 and
options self-clearing operations in April 1997. Prior to July 1996, the
Company cleared all of its customer transactions as a fully-disclosed
correspondent of Herzog, Heine, Geduld, Inc. ("Herzog"). Clearing services
include the
22
confirmation, receipt, settlement, custody and delivery functions involved in
securities transactions. In the first quarter of fiscal 1996, the Company
began hiring associates to perform these functions. As a consequence, the
Company incurred significant nonrecurring costs associated with the hiring and
training of its associates, as well as systems integration costs. The Company
continued to incur expenses for clearing operations performed by Herzog
through June 1996. The conversion to self-clearing has allowed the Company to
realize significant cost savings and revenue enhancement.
The Company now assumes direct responsibility for the possession and control
of customer securities and other customer assets and the clearance of
customers' securities transactions. Having this responsibility requires the
Company to record on its balance sheet the customer receivables and customer
payables to the Company that are a result of customer margin loans (i.e.,
loans made to customers that are collateralized by securities held in the
customers' margin accounts at the Company) and customer free credit balances
(i.e., customer cash balances maintained by the Company), respectively. In
addition, to the extent that the Company's customer debit balances exceed
customer free credit balances, the Company may be required to obtain financing
for any excess debit balance. The Company had receivables from customers,
brokers, dealers and clearing organizations of $724 million and payables to
customers, brokers, dealers and clearing organizations of $681 million as of
September 30, 1997. The Company contracts with a third-party service bureau,
Beta Systems, for its customer recordkeeping and data processing services,
having previously relied on Herzog for these services.
The Company's transaction revenues increased to $109.7 million in fiscal
1997 from $20.8 million in fiscal 1995. Transaction revenues include
securities brokerage transactions and, since late fiscal 1994, payments for
order flow. The Company recognized $4.0 million in international revenue in
fiscal 1997, representing $2.0 million in licensing fees attributable to the
Company's agreement with VERSUS Technologies, Inc. ("VERSUS") and $2.0 million
in licensing fees attributable to the Company's agreement with Nova Pacific
Capital Ltd. ("Nova Pacific"). These licensing agreements grant VERSUS,
through its subsidiary VERSUS Brokerage Services, Inc., and Nova Pacific the
exclusive right to offer online investing services under the E*TRADE name to
customers with addresses in Canada through VERSUS, and Australia and New
Zealand through Nova Pacific. Under these agreements, the Company receives
ongoing royalties from VERSUS and Nova Pacific based upon their transaction
revenues. The Company may, from time to time, seek to enter into similar
licensing agreements with others as part of its international expansion
strategy. There can be no assurance that any such future agreements will be
consummated or that the terms thereof will be comparable to those of the
aforementioned agreements or that the recognition of any licensing fees will
occur during the period in which an arrangement is consummated. Prior to
fiscal 1997, the Company did not recognize any international revenues.
Interest revenues, net of interest expense, increased to $25.3 million in
fiscal 1997 from $1.0 million in fiscal 1995. The Company previously
participated in the interest spread on its customer debit and credit balances
through its clearing agreement with Herzog, but is no longer subject to that
agreement as a result of its conversion to self-clearing operations.
Consequently, the Company now has greater control over interest rates charged
to customers for debit balances and interest rates paid for credit balances.
The Company began receiving fees on its customers' assets invested in money
market funds in September 1994, which fees were shared with Herzog until the
Company's change to self-clearing operations in July 1996.
Computer services and other revenues increased to $3.8 million in fiscal
1997 from $1.5 million in fiscal 1995. Computer services revenues consist
primarily of fees for the time customers are connected to the Company online.
Other revenues represent the Company's return on its investment in Roundtable
Partners LLC, a consortium of broker-dealers that provides the Company with
alternative broker-dealers through which to route its customers' orders for
execution. The Company also participates in the operating results of
Roundtable Partners LLC as an equity owner.
The Company's total cost of services increased to $70.8 million in fiscal
1997 from $13.5 million in fiscal 1995. Cost of services includes clearing
fees paid to the Company's former clearing broker, system maintenance and
communication expenses and expenses related to the Company's clearing
operations and customer service activities.
23
Selling and marketing expenses increased to $24.2 million in fiscal 1997
from $2.5 million in fiscal 1995 and consist primarily of the costs associated
with the actual advertising placement expenses as well as the creative
development of advertising.
Technology development expenses increased to $10.8 million in fiscal 1997
from $943,000 in fiscal 1995 and consist of payroll and consulting costs
associated with the development and enhancement of the Company's product
offerings. In addition to such amounts, the Company capitalized costs of $2.8
million in fiscal 1997 and $114,000 in fiscal 1996 for internally developed
software, which includes the cost of software tools and licenses used in the
development of the Company's systems, as well as payroll and consulting costs.
General and administrative expenses increased to $13.6 million in fiscal
1997 from $2.1 million in fiscal 1995 and consist primarily of facilities
costs, equipment and maintenance expenses, as well as corporate management
costs, including accounting, finance, human resources, compliance and other
administrative expenses.
The Company has experienced substantial changes in and expansion of its
business and operations since it began offering online investing services in
1992, and Internet investing services in February 1996, and expects to
continue to experience periods of rapid growth. The Company's past expansion
has placed, and any future expansion would place, significant demands on the
Company's administrative, operational, financial and other resources.
Competition for highly qualified senior managers and technical personnel is
intense. If the Company fails to attract, assimilate and retain such
personnel, there would be a material adverse effect on the Company's business,
financial condition and operating results.
The securities industry is subject to extensive regulation under federal,
state and applicable international laws. As a result, the Company is required
to comply with many complex laws and rules and its ability to so comply is
dependent in large part upon the establishment and maintenance of a qualified
compliance system. The Company is aware of several instances of its non-
compliance with applicable regulations. In particular, in fiscal 1997, the
Company failed to comply with applicable advertising restrictions in one
international jurisdiction and, due to a clerical oversight, failed to timely
renew its registration as a broker-dealer in two states, Nebraska and Ohio.
One of the states, Ohio, as a condition of renewing the Company's license as a
broker-dealer in that state, required the Company to offer customers resident
in that state the ability to rescind (for up to 30 days) certain securities
transactions effected through the Company during the period January 1, 1997
through April 15, 1997, the date the Company's license was renewed. For fiscal
1997, the Company recorded a one-time, $4.3 million pre-tax charge against
earnings in connection with this matter.
24
RESULTS OF OPERATIONS
The following table sets forth the percentage of net revenues represented by
certain items on the Company's consolidated statements of operations for the
periods indicated:
YEARS ENDED
SEPTEMBER 30,
--------------------
1997 1996 1995
----- ----- -----
Revenues:
Transaction revenues..................................... 76.8% 85.6% 89.3%
Interest, net of interest expense........................ 17.7 9.4 4.2
International............................................ 2.8 -- --
Computer services and other.............................. 2.7 5.0 6.5
----- ----- -----
Net revenues............................................ 100.0 100.0 100.0
----- ----- -----
Cost of services:
Cost of services......................................... 46.6 66.4 57.2
Registration charge...................................... 3.0 -- --
Self-clearing start-up costs............................. -- 4.3 0.6
----- ----- -----
Total cost of services.................................. 49.6 70.7 57.8
----- ----- -----
Operating expenses:
Selling and marketing.................................... 17.0 14.7 10.6
Technology development................................... 7.5 5.4 4.0
General and administrative............................... 9.5 11.8 9.1
----- ----- -----
Total operating expenses................................ 34.0 31.9 23.7
----- ----- -----
Total cost of services and operating expenses........... 83.6 102.6 81.5
----- ----- -----
Pre-tax income (loss)..................................... 16.4 (2.6) 18.5
Income tax expense (benefit).............................. 6.6 (1.0) 7.4
----- ----- -----
Net income (loss)......................................... 9.8% (1.6)% 11.1%
===== ===== =====
FISCAL YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
Revenues
Transaction revenues increased 148% to $109.7 million in fiscal 1997, up
from $44.2 million in fiscal 1996 and $20.8 million in fiscal 1995. This
increase is attributed to a 166% increase in average daily transactions to
16,382 in fiscal 1997 from 6,148 in fiscal 1996 and 2,335 in fiscal 1995.
Transaction revenues consist of commission revenues and payments for order
flow. Commission revenues increased 153% to $82.9 million, up from $32.8
million in fiscal 1996 and $16.2 million in fiscal 1995. Average commissions
per transaction decreased to $20.00 in fiscal 1997 from $20.82 in fiscal 1996
and $27.38 in fiscal 1995, due to the planned lowering of commissions on
listed market orders from $19.95 to $14.95 in February 1996. Payments for
order flow increased 135% to $26.8 million in fiscal 1997, up from $11.4
million in fiscal 1996 and $4.6 million in fiscal 1995. This increase is less
than the increase in total volume of transactions due to the introduction of
the new SEC order handling rules in January 1997.
Net interest revenues for fiscal 1997 increased 425% to $25.3 million, up
from $4.8 million in fiscal 1996 and $1.0 million in fiscal 1995, due to
growth in customer accounts and the opportunity that being self-clearing has
given the Company to manage interest rates. This increase was also a result of
average customer margin debit balances increasing 336% to $543 million,
average customer interest-earning credit balances increasing 308% to $218
million and average customer money market fund balances increasing 145% to
$714 million during the period, compared to the average balances during fiscal
1996 and 1995.
International revenues were $4.0 million in fiscal 1997, due to the
recognition of licensing fees attributable to the Company's agreements with
VERSUS, in the second quarter of fiscal 1997, and Nova Pacific, in the third
quarter of fiscal 1997, each for $2.0 million. There were no international
revenues in fiscal 1996 or 1995.
25
Computer services and other revenues increased 46% to $3.8 million in fiscal
1997, up from $2.6 million in fiscal 1996 and $1.5 million in fiscal 1995.
These revenues increased as a result of an increase in the profits from the
investment in Roundtable Partners LLC, partially offset by a decrease in
customer connect time charges.
Cost of Services
Total cost of services increased 94% to $70.8 million in fiscal 1997, up
from $36.5 million in fiscal 1996 and $13.5 million in fiscal 1995. Included
in total cost of services for fiscal 1997 was a charge of $4.3 million, which
resulted from a clerical oversight connected with the Company's failure to
timely renew its registration as a broker-dealer in the state of Ohio.
Included in total cost of services in fiscal 1996 were self-clearing start-up
costs of $2.2 million. Cost of services, exclusive of the registration charge
and self-clearing start-up costs, increased 94% to $66.5 million in fiscal
1997, up from $34.3 million in fiscal 1996 and $13.3 million in fiscal 1995.
This increase reflects the overall increase in customer transactions processed
by the Company, a related increase in customer service inquiries, and
operations and maintenance costs associated with the second operational data
center in Rancho Cordova, California beginning in July 1996.
Operating Expenses
Selling and marketing expenses increased 218% to $24.2 million in fiscal
1997, up from $7.6 million in fiscal 1996 and $2.5 million in fiscal 1995.
This increase reflects expenditures for advertising placements, creative
development and collateral materials resulting from a variety of advertising
campaigns directed at building brand name recognition, growing customer base
and market share, and maintaining customer retention rates. In addition, the
increase reflects the Company's national television advertising campaign
launched during the second quarter of fiscal 1997.
Technology development costs increased 285% to $10.8 million in fiscal 1997,
up from $2.8 million in fiscal 1996 and $943,000 in fiscal 1995. The fiscal
1997 level of expenses was incurred to enhance the Company's existing product
offerings, including maintenance of the Company's Web site, which was launched
in February 1996 and reflects the Company's continuing commitment to invest in
new products and technologies.
General and administrative expenses increased 124% to $13.6 million in
fiscal 1997, up from $6.1 million in fiscal 1996 and $2.1 million in fiscal
1995. The increase was the result of increased costs associated with personnel
additions, relocation to larger facilities, the development of administrative
functions resulting from the overall growth in the Company, and an increased
use of consultants by the Company in comparison to prior years.
Income Tax Expense (Benefit)
Income tax expense (benefit) represents the provision for federal and state
income taxes at an effective rate of 40.4% for fiscal 1997 and 40.1% for
fiscal 1996 and 1995.
VARIABILITY OF RESULTS
The Company expects to experience significant fluctuations in future
quarterly operating results that may be caused by many factors, including the
following: the timing of introductions of enhancements to online financial
services and products by the Company or its competitors; market acceptance of
online financial services and products; the pace of development of the market
for online commerce; changes in transaction volume on the securities markets;
trends in the securities markets; domestic and international regulation of the
brokerage industry; changes in pricing policies by the Company or its
competitors; changes in strategy; the success of or costs associated with
acquisitions or other strategic relationships; changes in key personnel;
seasonal trends; the extent of international expansion; the mix of
international and domestic sales; changes in the level of operating expenses
to support projected growth; and general economic conditions.
26
Due to the foregoing factors, quarterly revenues and operating results are
difficult to forecast, and the Company believes that period-to-period
comparisons of its operating results will not necessarily be meaningful and
should not be relied upon as an indication of future performance. It is likely
that the Company's future quarterly operating results from time to time will
not meet the expectations of securities analysts or investors, which may have
an adverse effect on the market price of the Company's Common Stock.
LIQUIDITY AND CAPITAL RESOURCES
In August 1996, the Company completed an initial public offering of its
Common Stock, resulting in net proceeds to the Company of approximately $46.4
million. The Company also has financed its activities through cash provided by
operations, the private placement of Preferred Stock, a secondary public
offering, and, to a lesser extent, equipment financing. In September 1995, the
Company privately placed $12.3 million of convertible Preferred Stock, of
which $3.8 million was used to repurchase and retire outstanding Common Stock.
In April and June 1996, the Company sold convertible Preferred Stock for an
aggregate of $11.8 million. All of the Company's Preferred Stock converted to
Common Stock upon the completion of the Company's initial public offering.
In August 1997, the Company completed a secondary public offering of
7,305,000 shares of the Company's Common Stock at a price of $27.50 per share.
The proceeds to the Company from the offering, net of underwriting discounts
and offering expenses of $14.8 million, were $188.8 million.
In July 1996, the Company obtained $100 million in authorized financing, to
be collateralized by customer securities. At September 30, 1997, $9.4 million
was outstanding under these lines, which was repaid on October 1, 1997. In
addition, the Company has entered into numerous agreements with other broker-
dealers to provide financing for the Company's stock loan activities.
The Company currently anticipates that its available cash resources and
credit facilities will be sufficient to meet its presently anticipated working
capital and capital expenditure requirements for at least the next 12 months.
However, the Company may need to raise additional funds in order to support
more rapid expansion, develop new or enhanced services and products, respond
to competitive pressures, acquire complementary businesses or technologies or
take advantage of unanticipated opportunities. The Company's future liquidity
and capital requirements will depend upon numerous factors, including costs
and timing of expansion of research and development efforts and the success of
such efforts, the success of the Company's existing and new service offerings
and competing technological and market developments. The Company's forecast of
the period of time through which its financial resources will be adequate to
support its operations is a forward-looking statement that involves risks and
uncertainties, and actual results could vary. The factors described earlier in
this paragraph will impact the Company's future capital requirements and the
adequacy of its available funds. If additional funds are raised through the
issuance of equity securities, the percentage ownership of the stockholders of
the Company will be reduced, stockholders may experience additional dilution
in net book value per share or such equity securities may have rights,
preferences or privileges senior to those of the holders of the Company's
Common Stock. There can be no assurance that additional financing will be
available when needed on terms favorable to the Company, if at all.
If adequate funds are not available on acceptable terms, the Company may be
unable to develop or enhance its services and products, take advantage of
future opportunities or respond to competitive pressures, any of which could
have a material adverse effect on the Company's business, financial condition
and operating results.
Cash used in operating activities was $9.6 million in fiscal 1997, primarily
as a result of increases in brokerage-related assets in excess of related
liabilities of $39.6 million, offset in part by net income during the period,
non-cash items included in net income and increases in accounts payable,
accrued and other liabilities in excess of other assets of $12.7 million. Cash
provided by (used in) operating activities in fiscal 1996 and 1995 was ($7.8)
million and $3.4 million, respectively. Such amounts reflect net income (loss)
for the respective periods and, in fiscal 1996, the impact of self-clearing
operations in the fourth quarter resulting in an increase in brokerage-related
assets in excess of related liabilities of $7.3 million.
27
Cash used in investing activities was $174.4 million in fiscal 1997 and
$45.8 million in fiscal 1996, primarily as a result of the investment of the
proceeds from the Company's secondary public offering of Common Stock in
August 1997 and initial public offering of Common Stock in August 1996.
Additionally, the Company made ongoing investments in its technological
infrastructure and the second data center in Rancho Cordova, and in fiscal
1997, a relocation loan to the Company's Chief Executive Officer (see Note 5
of Notes to Consolidated Financial Statements). Cash used for investing
activities in fiscal 1995 of $1.7 million primarily represents equipment
purchases.
Cash provided by financing activities was $191.1 million in fiscal 1997,
primarily due to net proceeds from the Company's secondary public offering and
the proceeds from exercise of stock options, compared with $58.6 million in
fiscal 1996, arising principally from the Company's initial public offering
and private sales of Preferred Stock. Cash provided by financing activities in
fiscal 1995 of $7.3 million reflects net proceeds from the Company's sale of
Preferred Stock, offset by repurchases of Common Stock and repayment of
obligations.
The Company expects that it will incur approximately $35 million of capital
expenditures for the 12 months ended September 30, 1998.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1996, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, effective for transfers of financial assets
made after December 31, 1996, except for certain financial assets for which
the effective date has been delayed until 1998 by SFAS No. 127, Deferral of
the Effective Date of Certain Provisions of SFAS No. 125. This new statement
provides accounting and reporting standards for transfers and servicing of
financial assets and extinguishments of liabilities. The Company does not
expect SFAS No. 125 to have a material effect on its consolidated financial
statements.
In February 1997, the FASB issued SFAS No. 128, Earnings per Share. The
Company is required to adopt SFAS No. 128 in the first quarter of fiscal 1998
and will restate at that time earnings per share ("EPS") data for prior
periods to conform with SFAS No. 128. Earlier application is not permitted.
SFAS No. 128 replaces current EPS reporting requirements and requires a dual
presentation of basic and diluted EPS. Basic EPS excludes dilution and is
computed by dividing net income by the weighted average number of common
shares outstanding for the period. Diluted EPS reflects the potential dilution
that could occur if securities or other contracts to issue common stock were
exercised or converted into common stock. If SFAS No. 128 had been in effect
during the periods presented, basic EPS would have been $.45, ($.05) and $.16
for the years ended September 30, 1997, 1996 and 1995, respectively. The
method used to calculate diluted EPS under SFAS No. 128 is the same as the
method used to calculate the EPS reported herein.
In June 1997, the FASB issued SFAS No. 130, Comprehensive Income, and SFAS
No. 131, Disclosures about Segments of an Enterprise. The Company is required
to adopt these statements for fiscal 1999. SFAS No. 130 establishes standards
for reporting comprehensive income and SFAS No. 131 establishes standards for
reporting information about operating segments. The Company has not completed
the process of evaluating the impact that will result from adopting SFAS No.
130 or 131.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
28
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Independent Auditors' Report............................................ 30
Consolidated Balance Sheets, September 30, 1997 and 1996................ 31
Consolidated Statements of Operations for Years Ended September 30,
1997, 1996 and 1995.................................................... 32
Consolidated Statements of Stockholders' Equity for Years Ended
September 30, 1997, 1996 and 1995...................................... 33
Consolidated Statements of Cash Flows for Years Ended September 30,
1997, 1996 and 1995.................................................... 34
Notes to Consolidated Financial Statements.............................. 35
SCHEDULES
All schedules have been omitted, as the required information is inapplicable
or the information is presented in the consolidated financial statements or
related notes.
29
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
E*TRADE Group, Inc.:
We have audited the accompanying consolidated balance sheets of E*TRADE
Group, Inc. and subsidiaries (the "Company") as of September 30, 1997 and
1996, and the related consolidated statements of operations, stockholders'
equity and cash flows for each of the three years in the period ended
September 30, 1997. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of E*TRADE Group, Inc. and
subsidiaries at September 30, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period
ended September 30, 1997 in conformity with generally accepted accounting
principles.
DELOITTE & TOUCHE LLP
San Jose, California
November 6, 1997 (November 21, 1997
as to the second paragraph of Note 11)
30
E*TRADE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
SEPTEMBER 30,
-----------------
1997 1996
-------- --------
ASSETS
Current assets:
Cash and equivalents........................................ $ 21,814 $14,641
Cash and investments required to be segregated under Federal
or other regulations....................................... 15,001 35,500
Investment securities....................................... 191,398 35,003
Brokerage receivables--net.................................. 724,365 193,228
Other assets................................................ 4,956 2,203
-------- --------
Total current assets....................................... 957,534 280,575
Property and equipment--net.................................. 18,802 9,228
Equity investment............................................ 3,519 2,860
Relocation loan receivable................................... 3,347 --
Other assets................................................. 6,701 2,218
-------- --------
Total assets............................................. $989,903 $294,881
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Brokerage payables.......................................... $681,106 $219,483
Bank loan payable........................................... 9,400 --
Accounts payable, accrued liabilities and other............. 18,122 6,094
-------- --------
Total liabilities.......................................... 708,628 225,577
-------- --------
Commitments and contingencies (Notes 10 and 11)
Stockholders' equity:
Preferred stock, $.01 par: shares authorized, 1,000,000;
Series A: 800,000 shares designated; shares issued and
outstanding: 1997, none; 1996, none......................... -- --
Common stock, $.01 par: shares authorized, 50,000,000; shares
issued and outstanding: September 1997, 38,657,328;
September 1996, 29,539,147.................................. 387 295
Additional paid-in capital................................... 266,712 68,738
Retained earnings............................................ 14,176 271
-------- --------
Total stockholders' equity................................. 281,275 69,304
-------- --------
Total liabilities and stockholders' equity............... $989,903 $294,881
======== ========
See notes to consolidated financial statements.
31
E*TRADE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
YEARS ENDED SEPTEMBER 30,
--------------------------
1997 1996 1995
--------- ------- -------
Revenues:
Transaction revenues.............................. $ 109,659 $44,178 $20,835
Interest--net of interest expense (A)............. 25,265 4,813 1,004
International..................................... 4,000 -- --
Computer services and other....................... 3,813 2,604 1,501
--------- ------- -------
Net revenues.................................... 142,737 51,595 23,340
--------- ------- -------
Cost of services:
Cost of services.................................. 66,507 34,268 13,340
Registration charge............................... 4,334 -- --
Self-clearing start-up costs...................... -- 2,240 141
--------- ------- -------
Total cost of services.......................... 70,841 36,508 13,481
--------- ------- -------
Operating expenses:
Selling and marketing............................. 24,193 7,600 2,466
Technology development............................ 10,761 2,792 943
General and administrative........................ 13,612 6,078 2,141
--------- ------- -------
Total operating expenses........................ 48,566 16,470 5,550
--------- ------- -------
Total cost of services and operating expenses... 119,407 52,978 19,031
--------- ------- -------
Pre-tax income (loss)............................... 23,330 (1,383) 4,309
Income tax expense (benefit)........................ 9,425 (555) 1,728
--------- ------- -------
Net income (loss)................................... $ 13,905 $ (828) $ 2,581
========= ======= =======
Net income (loss) per share......................... $ 0.40 $ (0.03) $ 0.10
========= ======= =======
Weighted average number of common and common
equivalent shares outstanding...................... 34,574 28,564 26,481
========= ======= =======
(A) Interest is presented net of interest expense of $14,909, $2,224 and $83
for the years ended 1997, 1996 and 1995, respectively.
See notes to consolidated financial statements.
32
E*TRADE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands)
PREFERRED TOTAL
STOCK COMMON STOCK ADDITIONAL RETAINED STOCKHOLDERS'
------------- -------------- PAID-IN EARNINGS EQUITY
SHARES AMOUNT SHARES AMOUNT CAPITAL (DEFICIT) (DEFICIENCY)
------ ------ ------ ------ ---------- --------- -------------
BALANCE, OCTOBER
1, 1994................ 14,954 $149 1,241 $(1,482) $ (92)
Net income.............. 2,581 2,581
Issuance of Series A
preferred stock........ 100 $ 1 12,299 12,300
Exercise of stock
warrants............... 1,293 13 13
Exercise of stock
options................ 497 5 141 146
Repurchase of common
stock.................. (1,853) (18) (3,782) (3,800)
---- ------ ------ ---- -------- ------- --------
BALANCE, SEPTEMBER 30,
1995................... 100 1 14,891 149 9,899 1,099 11,148
Net loss................ (828) (828)
Issuance of Series B
preferred stock, net of
issuance costs......... 20 2,837 2,837
Issuance of Series C
preferred stock, net of
issuance costs......... 11 8,950 8,950
Initial public offering,
net of issuance costs.. 5,027 50 46,352 46,402
Conversion of preferred
stock.................. (131) (1) 7,891 79 (78) --
Exercise of stock
warrants, including tax
benefit................ 403 4 286 290
Exercise of stock
options, including tax
benefit................ 1,320 13 472 485
Issuance of common stock
for services........... 7 20 20
---- ------ ------ ---- -------- ------- --------
BALANCE, SEPTEMBER 30,
1996................... -- -- 29,539 295 68,738 271 69,304
Net income.............. 13,905 13,905
Issuance of common
stock, net of issuance
costs.................. 7,305 73 188,752 188,825
Exercise of stock
options, including tax
benefit................ 1,739 18 8,535 8,553
Employee Stock Purchase
Plan................... 74 1 687 688
---- ------ ------ ---- -------- ------- --------
BALANCE, SEPTEMBER 30,
1997................... -- $ -- 38,657 $387 $266,712 $14,176 $281,275
==== ====== ====== ==== ======== ======= ========
See notes to consolidated financial statements.
33
E*TRADE GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
YEARS ENDED SEPTEMBER 30,
---------------------------
1997 1996 1995
-------- -------- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)................................. $ 13,905 $ (828) $ 2,581
Non-cash items included in net income (loss):
Deferred income taxes............................ 1,704 (487) 303
Depreciation and amortization.................... 3,566 876 230
Income earned on equity investment............... (1,785) (228) (353)
Other............................................ 21 107 67
Net effect of changes in broker-related assets and
liabilities:
Cash and investments required to be segregated
under Federal or other regulations.............. 20,499 (35,500) --
Brokerage receivables............................ (531,137) (191,292) (1,437)
Brokerage payables............................... 461,623 219,483 --
Bank loan payable................................ 9,400 -- --
Other changes, net:
Other assets..................................... (4,088) (2,998) (113)
Accounts payable, accrued liabilities and other.. 16,741 3,101 2,095
-------- -------- -------
Net cash provided by (used in) operating
activities....................................... (9,551) (7,766) 3,373
-------- -------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment................ (12,468) (8,733) (1,375)
Internally developed software..................... (2,832) (114) --
Purchase of equity investment..................... -- (2,000) --
Purchase of investment securities................. (993,282) (337,073) (504)
Sale/maturity of investment securities............ 836,877 302,070 --
Relocation loan................................... (3,347) -- --
Distributions received from equity investments.... 658 44 181
-------- -------- -------
Net cash used in investing activities............. (174,394) (45,806) (1,698)
-------- -------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock, net of
issuance costs................................... 188,825 46,402 --
Proceeds from issuance of preferred stock, net of
issuance costs................................... -- 11,787 12,300
Proceeds from exercise of stock options........... 1,627 310 146
Proceeds from exercise of stock warrants.......... -- 113 13
Proceeds from Employee Stock Purchase Plan........ 688 -- --
Repurchase of common stock........................ -- -- (3,800)
Proceeds from long-term note payable.............. -- 2,500 --
Repayment of long-term note payable............... -- (2,500) (1,381)
Repayment of capital leases....................... (22) (23) (21)
-------- -------- -------
Net cash provided by financing activities......... 191,118 58,589 7,257
-------- -------- -------
INCREASE IN CASH AND EQUIVALENTS.................. 7,173 5,017 8,932
CASH AND EQUIVALENTS--Beginning of period......... 14,641 9,624 692
-------- -------- -------
CASH AND EQUIVALENTS--End of period............... $ 21,814 $ 14,641 $ 9,624
======== ======== =======
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest............................ $ 13,440 $ 2,013 $ 399
======== ======== =======
Cash paid for income taxes........................ $ 1,205 $ 1,025 $ 830
======== ======== =======
Non-cash financing activities:
Tax benefit on exercise of stock options and
warrants........................................ $ 6,926 $ 352 $ --
======== ======== =======
See notes to consolidated financial statements.
34
E*TRADE GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation--The consolidated financial statements include E*TRADE
Group, Inc. and its subsidiaries (collectively, the "Company"), E*TRADE
Securities, Inc. ("E*TRADE Securities") and E*TRADE Capital, Inc., securities
broker-dealers. The Company has four locations in California, and as of
September 30, 1997 and 1996, approximately 25% of E*TRADE Securities' customer
accounts were located in California. All intercompany balances and
transactions have been eliminated.
Transaction Revenues--The Company derives revenues from commissions related
to customer transactions in equity and debt securities, options and, to a
lesser extent, payments from other broker-dealers for order flow. Securities
transactions are recorded on a trade date basis and are executed by
independent broker-dealers. Through June 1996, the Company did not receive or
hold customers' securities or funds. The Company implemented self-clearing
operations and took custody of securities and funds in customer accounts in
July 1996.
Interest, Net of Interest Expense--Prior to July 1996, these amounts
represent the Company's participation in the interest differential on its
customer debit and credit balances through a contractual agreement with its
former clearing broker, and fees on its customer assets invested in money
market accounts. Subsequent to the implementation of self-clearing operations
in July 1996, these amounts primarily represent interest earned by the Company
on credit extended to its customers to finance their purchases of securities
on margin, fees on its customer assets invested in money market accounts and
interest earned on investment securities, offset by interest paid to customers
on certain credit balances and interest paid to other broker-dealers through
the Company's stock loan program.
International Revenue--International revenue represents fees from the
licensing of rights which allow the licensees to offer on-line investing
services using the E*TRADE brand name in their foreign countries. Under the
agreements the Company will receive ongoing royalties.
Computer Services Revenue--Computer services revenue represents connect time
charges for direct modem access and touch-tone telephone customers. Such
revenues are recorded as earned.
Depreciation and Amortization--Furniture and fixtures, software and
equipment are stated at cost and are depreciated on a straight-line basis over
their estimated useful lives, generally three to seven years. Leasehold
improvements are stated at cost and are amortized over the lesser of their
useful lives or the life of the lease.
Technology Development Costs--Technology development costs are charged to
operations as incurred. Technology development costs include costs incurred in
the development and enhancement of software used in connection with services
provided by the Company that do not otherwise qualify as internally developed
software costs. The cost of internally developed software is capitalized and
included in other assets. The costs to develop such software are capitalized
when management authorizes and commits to funding a project it believes will
be completed and used to perform the functions intended and the conceptual
formulation, design and testing of possible software project alternatives have
been completed. Pilot projects and projects where expected future economic
benefits are less than probable are not eligible for capitalization.
Internally developed software costs include the cost of software tools and
licenses used in the development of the Company's systems, as well as payroll
and consulting costs. Capitalized costs totaled $2,832,000, $114,000 and $0
for the years ended September 30, 1997, 1996 and 1995, respectively.
35
Completed projects are transferred to property and equipment and are
reported at the lower of unamortized cost or net realizable value.
Amortization is based on the straight-line method over the estimated useful
life, generally two to three years. Amortization expense for the year ended
September 30, 1997 was $69,000. There was no amortization expense for the
years ended September 30, 1996 or 1995.
Cash Equivalents--For purposes of reporting cash flows, the Company
considers all highly liquid investments with original maturities of three
months or less (except for amounts required to be segregated under Federal or
other regulations or investment securities designated as available for sale)
to be cash equivalents.
Cash and Investments Required to be Segregated Under Federal or Other
Regulations--Cash and investments required to be segregated under Federal or
other regulations consist primarily of securities purchased under agreements
to resell ("Resale Agreements"). Resale Agreements are accounted for as
collateralized financing transactions and are recorded at their contractual
amounts.
Investments--Investment securities represent a portfolio of commercial
paper, municipal bonds, corporate bonds, preferred stocks and money market
funds. The cost of these investments approximates fair market value, and
management has designated them as available for sale. Unrealized gains and
losses, net of tax, are computed on the basis of average cost and are included
in retained earnings. Realized gains and losses and declines in fair-value,
judged to be other than temporary, are included in other revenues. The cost of
securities sold is based on the average cost method and interest earned is
included in interest revenue.
Equity investment represents the Company's investment in a limited liability
company, Roundtable Partners LLC ("Roundtable"), which is accounted for using
the equity method. The Company's return on its investment in Roundtable is
included in other revenues. Roundtable is a consortium of broker-dealers.
Estimated Fair-Value of Financial Instruments--The Company believes the
amounts presented for financial instruments on the consolidated balance sheets
consisting of cash equivalents, commercial paper, municipal bonds, corporate
bonds, preferred stocks, money market funds, and brokerage receivables and
payables to be reasonable estimates of fair-value. The Company uses available
market information as of the balance sheet dates and appropriate valuation
methodologies in deriving amounts reported for financial instruments.
Use of Estimates--The preparation of the Company's consolidated financial
statements in conformity with generally accepted accounting principles
necessarily requires management to make estimates and assumptions that affect
the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the balance sheet dates and the reported amounts of
revenues and expenses for the periods presented.
Stock-Based Compensation--As permitted by Statement of Financial Accounting
Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, the
Company accounts for its stock-based compensation on the intrinsic-value
method in accordance with Accounting Principles Board ("APB") Opinion No. 25.
Advertising Costs--Advertising costs are expensed when the initial
advertisement is run.
Income Taxes--The Company accounts for income taxes in accordance with SFAS
No. 109, Accounting for Income Taxes, which requires the recognition of
deferred tax liabilities and assets at tax rates expected to be in effect when
these balances reverse. Future tax benefits attributable to temporary
differences are recognized to the extent that realization of such benefits is
more likely than not. Income tax expense for each of the three years in the
period ended September 30, 1997 is computed based on the expected effective
tax rate for the year ended September 30, 1997.
36
Long-lived Assets--The Company adopted SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,
effective October 1, 1996. The adoption did not have a material impact on the
consolidated financial statements.
Earnings Per Share--Earnings per share is based on the fully diluted
weighted average number of common and common equivalent shares outstanding
during the period. Pursuant to rules of the Securities and Exchange
Commission, all common and common equivalent shares issued and options,
warrants and other rights to acquire shares of common stock at a price less
than the initial public offering price granted by the Company during the 12
months preceding the offering date (using the treasury stock method until
shares are issued) have been included in the computation of common and common
equivalent shares outstanding for all periods prior to the initial public
offering (see Note 8).
Recently Issued Accounting Standards--In June 1996, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 125, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, effective
for transfers of financial assets made after December 31, 1996, except for
certain financial assets for which the effective date has been delayed until
1998 by SFAS No. 127, Deferral of the Effective Date of Certain Provisions of
SFAS No. 125. This new statement provides accounting and reporting standards
for transfers and servicing of financial assets and extinguishments of
liabilities. The Company does not expect SFAS No. 125 to have a material
effect on its consolidated financial statements.
In February 1997, the FASB issued SFAS No. 128, Earnings per Share. The
Company is required to adopt SFAS No. 128 in the first quarter of fiscal 1998
and will restate at that time earnings per share ("EPS") data for prior
periods to conform with SFAS No. 128. Earlier application is not permitted.
SFAS No. 128 replaces current EPS reporting requirements and requires a dual
presentation of basic and diluted EPS. Basic EPS excludes dilution and is
computed by dividing net income by the weighted average number of common
shares outstanding for the period. Diluted EPS reflects the potential dilution
that could occur if securities or other contracts to issue common stock were
exercised or converted into common stock. If SFAS No. 128 had been in effect
during the periods presented, basic EPS would have been $.45, ($.05) and $.16
for the years ended September 30, 1997, 1996 and 1995, respectively. The
method used to calculate diluted EPS under SFAS No. 128 is the same as the
method used to calculate the EPS reported herein.
In June 1997, the FASB issued SFAS No. 130, Comprehensive Income, and SFAS
No. 131, Disclosures about Segments of an Enterprise. The Company is required
to adopt these statements for fiscal 1999. SFAS No. 130 establishes standards
for reporting comprehensive income and SFAS No. 131 establishes standards for
reporting information about operating segments. The Company has not completed
the process of evaluating the impact that will result from adopting SFAS No.
130 or 131.
Reclassifications--Certain items in these financial statements have been
reclassified to conform to the current period presentation.
37
2. INVESTMENT SECURITIES
The Company invests in high quality, short-term investments, which it
classifies as available-for-sale. As such, there were no significant
differences between amortized cost and estimated fair value at September 30,
1997 or 1996. Additionally, because investments are short-term and are
generally allowed to mature, realized gains and losses for both years were
minimal and there were no significant changes in net unrealized gains and
losses.
The following table presents the estimated fair value breakdown of
investment securities by category (in thousands):
SEPTEMBER 30,
----------------
1997 1996
-------- -------
Commercial paper......................................... $ 67,062 $29,749
Money market funds....................................... 61,879 178
Municipal bonds.......................................... 43,904 --
Corporate bonds.......................................... 10,927 2,541
Preferred stocks......................................... 7,626 --
US Government notes...................................... -- 2,535
-------- -------
Total investment securities............................ $191,398 $35,003
======== =======
3. BROKERAGE RECEIVABLES AND PAYABLES--NET
Brokerage receivables and payables--net consists of the following (in
thousands):
SEPTEMBER 30,
-----------------
1997 1996
-------- --------
Receivable from customers (less allowance for doubtful
accounts of
$435 and $129 in 1997 and 1996, respectively)......... $655,981 $168,777
Receivable from brokers, dealers and clearing organiza-
tions:
Net settlement and deposits with clearing organiza-
tions................................................ 37,198 16,018
Deposits paid for securities borrowed................. 25,584 5,804
Securities failed to deliver.......................... 1,011 214
Other................................................. 4,591 2,415
-------- --------
Total brokerage receivables--net..................... $724,365 $193,228
======== ========
Payable to customers................................... $279,348 $183,561
Payable to brokers, dealers and clearing organizations:
Deposits received for securities loaned............... 398,007 33,576
Securities failed to receive.......................... 1,304 494
Other................................................. 2,447 1,852
-------- --------
Total brokerage payables............................. $681,106 $219,483
======== ========
Receivable from and payable to brokers, dealers and clearing organizations
result from the Company's brokerage activities. Receivable from customers
represents credit extended to customers to finance their purchases of
securities on margin. At September 30, 1997 and 1996, credit extended to
customers with respect to margin accounts was $678 million and $171 million,
respectively. Securities owned by customers are held as collateral for amounts
due on margin balances (the value of which is not reflected on the
accompanying consolidated balance sheets). Payable to customers represents
free credit balances and other customer funds pending completion of securities
transactions. The Company pays interest on certain customer credit balances.
38
4. PROPERTY AND EQUIPMENT--NET
Property and equipment--net consists of the following (in thousands):
SEPTEMBER 30,
--------------
1997 1996
------- ------
Equipment.................................................. $11,302 $6,221
Leasehold improvements..................................... 6,478 4,164
Software................................................... 5,664 --
Furniture and fixtures..................................... 768 706
------- ------
24,212 11,091
Less accumulated depreciation and amortization............. 5,410 1,863
------- ------
Total property and equipment-net......................... $18,802 $9,228
======= ======
5. RELATED-PARTY TRANSACTIONS
During fiscal 1997, the Company made a relocation loan to Mr. Christos
Cotsakos, its Chief Executive Officer and a Director, in the aggregate
principal amount of $3,147,000. The proceeds of this loan were used to fund
the purchase by Mr. Cotsakos of a personal residence in the Silicon Valley
area. The relocation loan accrues interest at the rate of 7% per annum which,
together with the principal amount, is due and payable in November 1999.
Accrued interest was $200,000 as of September 30, 1997. The loan is required
to be collateralized by a combination of assets, including the residence
purchased. The due date of the relocation loan is subject to acceleration upon
the occurrence of certain events including the voluntary cessation of
employment with the Company by Mr. Cotsakos.
In June 1997, the Company invested $2,000,000 in KAP Group, LLC ("KAP
Group"), by means of a promissory note in the principal amount of $1,805,951
and through the purchase of a warrant for $194,049. The note bears interest at
7% per annum which, together with the principal amount, is due and payable in
July 2002. The warrant gives the Company the right to purchase shares of KAP
Group. KAP Group intends to invest substantially all of its assets in another
entity which will be formed for the purpose of engaging in securities trading.
KAP Group investors include the Company, the Company's Chairman of the Board
of Directors and others.
6. LONG-TERM NOTES PAYABLE AND SHORT-TERM FUNDING
During fiscal 1996, the Company used $2.5 million of the proceeds from its
initial public offering (see Note 8) to repay a term loan originally obtained
in February 1996 to finance the purchase of equipment and leasehold
improvements. Interest was accrued at the per annum rate equal to the sum of
2.70% over the 30-Day Commercial Paper Rate as defined. There was no
prepayment penalty.
The principal source of financing for E*TRADE Securities' margin lending is
cash balances in customers' accounts and financing obtained from other broker-
dealers through E*TRADE Securities' stock loan program. E*TRADE Securities
also maintains committed lines of financing with banks totaling $100 million
to finance margin lending. At September 30, 1997, $9,400,000 was outstanding
under these lines, bearing interest at 6.875% per annum, which was repaid on
October 1, 1997; such amount is recorded as bank loan payable in the
consolidated balance sheet. There were no borrowings outstanding under these
lines at September 30, 1996.
39
7. INCOME TAXES
The components of income tax expense (benefit) are as follows (in
thousands):
YEARS ENDED
SEPTEMBER 30,
---------------------
1997 1996 1995
------ ----- ------
Current:
Federal............................................ $5,499 $ (66) $1,030
State.............................................. 2,222 (2) 395
------ ----- ------
Total current..................................... 7,721 (68) 1,425
------ ----- ------
Deferred:
Federal............................................ 1,727 (441) 302
State.............................................. (23) (46) 1
------ ----- ------
Total deferred.................................... 1,704 (487) 303
------ ----- ------
Total tax expense (benefit)......................... $9,425 $(555) $1,728
====== ===== ======
Deferred income taxes are recorded when revenues and expenses are recognized
in different periods for financial statement and tax return purposes. The
temporary differences and tax carryforwards that created deferred tax
assets(liabilities) are as follows (in thousands):
SEPTEMBER 30,
-----------------
1997 1996 1995
----- ----- ----
Deferred tax assets:
Reserves and allowances................................ $ 412 $ 215 $156
Net operating loss carryforwards....................... 487 804 --
Other.................................................. 697 226 141
----- ----- ----
Total deferred tax assets............................. 1,596 1,245 297
----- ----- ----
Deferred tax liabilities:
Depreciation and amortization.......................... 2,292 284 3
Equity investment...................................... 227 180 --
Other.................................................. 8 8 8
----- ----- ----
Total deferred tax liabilities........................ 2,527 472 11
----- ----- ----
Net deferred tax asset (liability) included in other as-
sets (liabilities)..................................... $(931) $ 773 $286
===== ===== ====
There were no valuation allowances associated with the deferred tax assets
at September 30, 1997, 1996 and 1995.
The effective tax rates differed from the federal statutory rates as
follows:
YEARS ENDED
SEPTEMBER 30,
----------------
1997 1996 1995
---- ---- ----
Tax expense at federal statutory rate................... 35.0% 35.0% 35.0%
State income taxes, net of federal tax benefit.......... 6.2 2.3 6.1
Other................................................... (0.8) 2.8 (1.0)
---- ---- ----
Effective tax rate...................................... 40.4% 40.1% 40.1%
==== ==== ====
40
8. STOCKHOLDERS' EQUITY
Stock Issuances
In September 1995, the Company sold 100,000 shares of Series A Preferred
Stock ("Series A") to General Atlantic Partners for $12,300,000. The Company
used approximately $3,800,000 of the proceeds to repurchase and retire
outstanding common stock from existing stockholders.
In April 1996, the Company sold 20,336 shares of Series B Preferred Stock
("Series B") to Christos Cotsakos, Chief Executive Officer and a Director, and
affiliates, Richard Braddock, and General Atlantic Partners and affiliates for
$2,847,000 and incurred issuance costs of $10,000. The Company used the
proceeds to provide additional working capital.
In June 1996, the Company sold 11,180 shares of Series C Preferred Stock
("Series C") to SOFTBANK Holdings Inc. for $9,000,000 and incurred issuance
costs of $50,000. The Company used the proceeds to provide additional
regulatory net capital to E*TRADE Securities.
In August 1996, the Company completed an initial public offering of
5,026,550 shares of the Company's common stock at a price of $10.50 per share.
Each share of Series A, Series B and Series C Preferred Stock was
automatically converted into 60 shares of common stock upon the closing of the
initial public offering. The proceeds to the Company from the offering, net of
underwriting discounts and offering expenses of $6.4 million, were $46.4
million.
In August 1997, the Company completed a secondary public offering of
7,305,000 shares of the Company's common stock at a price of $27.50 per share.
The proceeds to the Company from the offering, net of underwriting discounts
and offering expenses of $14.8 million, were $188.8 million.
Stock Option Plans
The Company's stock option plans provide for the granting of nonqualified or
incentive stock options to officers, directors, key employees and consultants
for the purchase of shares of the Company's common stock at a price determined
by the Board of Directors at the date the option is granted. The options are
generally exercisable ratably over a five-year period from the date the option
is granted and expire within ten years from the date of grant.
In April 1993, the stockholders of the Company approved the 1993 Stock
Option Plan (the "1993 Plan"), which authorized 1,800,000 shares of the
Company's common stock as available for the granting of options. Through April
1996, the authorized number of shares was increased to 5,400,000.
In July 1996, the stockholders of the Company approved the 1996 Stock
Incentive Plan (the "1996 Plan") and reserved 4,000,000 shares of common stock
for future grants. Following adoption, no additional grants may be made under
the 1993 Plan. The 1996 Plan is divided into three components: the
Discretionary Option Grant Program, the Stock Issuance Program and the
Automatic Option Grant Program. Under the Discretionary Option Grant Program,
options may be granted to purchase shares of common stock at an exercise price
not less than the fair market value of those shares on the grant date to
eligible employees. The Stock Issuance Program allows for individuals to be
issued shares of common stock directly through the purchase of such shares at
a price not less than the fair market value of those shares at the time of
issuance or as a bonus tied to the performance of services. Under the
Automatic Option Grant Program, options are automatically granted at periodic
intervals to eligible non-employee members of the Board of Directors to
purchase shares of common stock at an exercise price equal to the fair market
value of those shares on the grant date.
41
A summary of stock option activity follows:
WEIGHTED
AVERAGE
NUMBER EXERCISE
OF SHARES PRICE
---------- --------
Outstanding at September 30, 1994..................... 3,300,000 $ .25
Granted.............................................. 1,776,000 $ .47
Canceled............................................. (876,000) $ .32
Exercised............................................ (497,100) $ .28
---------- ------
Outstanding at September 30, 1995..................... 3,702,900 $ .33
Granted.............................................. 4,045,000 $ 5.18
Canceled............................................. (157,200) $ 6.29
Exercised............................................ (1,320,060) $ .21
---------- ------
Outstanding at September 30, 1996..................... 6,270,640 $ 3.28
Granted.............................................. 2,615,100 $21.33
Canceled............................................. (983,200) $ 6.95
Exercised............................................ (1,738,900) $ .91
---------- ------
Outstanding at September 30, 1997..................... 6,163,640 $11.11
---------- ------
SEPTEMBER 30,
-----------------------------
1997 1996 1995
--------- --------- ---------
Options available for grant.................. 1,579,200 3,184,100 900,000
Options exercisable.......................... 735,859 959,040 1,490,000
Additional information regarding options outstanding as of September 30,
1997, is as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------- -----------------------
WEIGHTED
NUMBER AVERAGE WEIGHTED NUMBER WEIGHTED
RANGE OF OUTSTANDING CONTRACTUAL AVERAGE EXERCISABLE AVERAGE
EXERCISEABLE AS OF LIFE EXERCISE AS OF EXERCISE
PRICES 9/30/97 (YEARS) PRICE 9/30/97 PRICE
- -------------- ----------- ----------- -------- ----------- --------
$ .28--$ 2.05 1,261,020 7.78 $ 1.03 241,020 $ .72
$ 2.33--$ 2.33 1,222,500 6.32 $ 2.33 159,299 $ 2.33
$ 5.50--$10.50 1,339,020 7.19 $ 8.87 331,740 $ 8.33
$10.57--$24.76 1,219,500 9.45 $17.81 3,800 $11.54
$25.13--$27.91 1,049,100 9.87 $26.94 0 $ 0.00
$28.19--$46.00 72,500 9.93 $34.27 0 $ 0.00
- -------------- --------- ---- ------ ------- ------
$ .28--$46.00 6,163,640 8.07 $11.11 735,859 $ 4.56
- -------------- --------- ---- ------ ------- ------
Warrants
During 1995, warrants that had been issued to the Company's creditors in June
1990 in connection with a restructuring agreement (the "Restructuring
Warrants") to purchase 1,263,240 shares of common stock were exercised for
$206. The remaining Restructuring Warrants expired in June 1995. In January
1995, a consultant was granted a warrant to purchase 300,000 shares of the
Company's common stock at $.42 per share, of which 29,880 were exercised in
fiscal 1995 and the remainder in fiscal 1996.
Stock Purchase Plan
In July 1996, the stockholders of the Company approved the 1996 Stock
Purchase Plan (the "Purchase Plan") and reserved 650,000 shares of common stock
for sale to employees at a price no less than 85% of the lower of the fair
market value of the common stock at the beginning of the two-year offering
period or the end of each of the six-month purchase periods.
42
401(k) Salary Deferral Program
The Company has a 401(k) salary deferral program, which became effective on
January 1, 1995, for eligible employees who have met certain service
requirements. The Company matches certain employee contributions; additional
contributions to this plan are at the discretion of the Company. Total Company
contribution expense for the years ended September 30, 1997, 1996 and 1995 was
$136,000, $52,000 and $6,000, respectively.
Additional Stock Plan Information
As discussed in Note 1, the Company continues to account for its stock-based
awards using the intrinsic value method in accordance with APB No. 25,
Accounting for Stock Issued to Employees, and its related interpretations.
Accordingly, no compensation expense has been recognized in the financial
statements for employee stock arrangements.
SFAS No. 123, Accounting for Stock-Based Compensation, requires the
disclosure of pro forma net income and earnings per share had the Company
adopted the fair value method as of the beginning of fiscal 1996. Under SFAS
No. 123, the fair value of stock-based awards to employees is calculated using
the minimum value method for all periods prior to the initial public offering,
and subsequently through the use of option pricing models, even though such
models were developed to estimate the fair value of freely tradable, fully
transferable options without vesting restrictions, which significantly differ
from the Company's stock option awards. These models also require subjective
assumptions, including future stock price volatility and expected time to
exercise, which greatly affect the calculated values. The Company's
calculations were made using the minimum value method and Black-Scholes option
pricing models with the following weighted average assumptions: expected life,
12 months following vesting; stock volatility, 65% subsequent to the initial
public offering in August 1996; risk-free interest rates, 6% in fiscal 1997
and 1996; and no dividends during the expected term. The Company's
calculations are based on a multiple option valuation approach and forfeitures
are recognized as they occur. The computed weighted average fair values of
option grants in fiscal 1997 and 1996 were $11.58 per share and $1.64 per
share, respectively. If the computed fair values of fiscal 1997 and fiscal
1996 awards had been amortized to expense over the vesting period of the
awards, fiscal 1997 pro forma net income would have been $9,902,000 ($.29 per
share) and fiscal 1996 pro forma net loss would have been $1,157,000 ($.04 per
share). However, because options vest over several years and grants prior to
fiscal 1996 are excluded from these calculations, these amounts may not be
representative of the impact on future years' earnings, assuming grants are
made in those years.
9. REGULATORY REQUIREMENTS
E*TRADE Securities is subject to the Uniform Net Capital Rule (the "Rule")
under the Securities Exchange Act of 1934 administered by the Securities and
Exchange Commission and the National Association of Securities Dealers, Inc.,
which requires the maintenance of minimum net capital. E*TRADE Securities has
elected to use the alternative method permitted by the Rule, which requires
that the Company maintain minimum net capital equal to the greater of $250,000
or 2 percent of aggregate debit balances arising from customer transactions,
as defined. E*TRADE Securities had amounts in relation to the Rule as follows
(in thousands, except percentage data):
SEPTEMBER 30,
----------------
1997 1996
------- -------
Net capital.............................................. $51,721 $17,117
Percentage of aggregate debit balances................... 7.5% 9.2%
Required net capital..................................... $13,771 $ 3,703
Excess net capital....................................... $37,950 $13,414
43
Under the alternative method, a broker-dealer may not repay subordinated
borrowings, pay cash dividends or make any unsecured advances or loans to its
parent or employees if such payment would result in net capital of less than
5% of aggregate debit balances or less than 120% of its minimum dollar amount
requirement.
10. LEASE ARRANGEMENTS
The Company has four non-cancelable operating leases for office facilities
through 2006 and operating leases for equipment through 2001. Future minimum
rental commitments under these leases at September 30, 1997, are as follows
(in thousands):
Years ending September 30:
1998............................................................. $12,892
1999............................................................. 12,116
2000............................................................. 6,041
2001............................................................. 2,559
2002............................................................. 1,402
Thereafter....................................................... 4,004
Certain leases contain provisions for renewal options and rent escalations
based on increases in certain costs incurred by the lessor. Rent expense for
the years ended September 30, 1997, 1996 and 1995 was approximately
$10,925,000, $2,441,000 and $344,000, respectively.
11. COMMITMENTS, CONTINGENCIES AND REGULATORY MATTERS
The Company is a defendant in civil actions arising from the normal course
of business. In the opinion of management, these actions are expected to be
resolved with no material effect on the Company's consolidated financial
position or results of operations.
On November 21, 1997, a putative class action complaint was filed in the
Superior Court of California, County of Santa Clara, by Larry R. Cooper and
other similarly situated individuals, seeking injunctive and other relief due
to the Company's alleged false and deceptive advertising and other
communications regarding the Company's commissions rates and the Company's
ability to execute transactions in a timely manner. The complaint seeks
injunctive relief enjoining alleged deceptive and unfair practices alleged in
the complaint and unqualified compensatory and punitive damages. This
proceeding is at a very early stage and the Company is unable to speculate as
to its ultimate outcome, however, management does not expect the outcome to
have a material effect on its consolidated financial position or results of
operations.
During the quarter ended March 31, 1997, the Company became aware of several
instances of its non-compliance with applicable broker-dealer regulations. In
particular, the Company failed to comply with applicable advertising
restrictions in one international jurisdiction, and due to a clerical
oversight failed to renew its registration as a broker-dealer in two states.
One of the state jurisdictions, as a condition of renewing the Company's
license as a broker-dealer in that jurisdiction, required the Company to offer
resident customers of that state the ability to rescind (for up to 30 days)
certain securities transactions affected through the Company during the period
January 1, 1997, through April 15, 1997, the date the Company's license was
renewed. For fiscal 1997, the company recorded a one-time $4.3 million pre-tax
charge against earnings in connection with this matter.
In March 1996, the Company entered into a five-year employment agreement
with a key executive officer. The employment agreement provides for, among
other things, an annual base salary which is subject to adjustment based on
the Company's performance and a severance payment up to $1,250,000 in the
event of termination of employment under certain defined circumstances.
44
12. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET CREDIT RISK AND
CONCENTRATIONS OF CREDIT RISK
The Company's customer securities activities are transacted on either a cash
or margin basis. In margin transactions, the Company extends credit to the
customer, subject to various regulatory and internal margin requirements,
collateralized by cash and securities in the customer's account. As customers
write option contracts or sell securities short, the Company may incur losses
if the customers do not fulfill their obligations and the collateral in
customer accounts is not sufficient to fully cover losses which customers may
incur from these strategies. To control this risk, the Company monitors
required margin levels daily, and customers are required to deposit additional
collateral, or reduce positions, when necessary.
Through its broker-dealer subsidiaries, the Company loans securities
temporarily to other brokers in connection with its securities lending
activities. The Company receives cash as collateral for the securities loaned.
Increases in security prices may cause the market value of the securities
loaned to exceed the amount of cash received as collateral. In the event the
counterparty to these transactions does not return the loaned securities, the
Company may be exposed to the risk of acquiring the securities at prevailing
market prices in order to satisfy its customer obligations. The Company
controls this risk by requiring credit approvals for counterparties, by
monitoring the market value of securities loaned on a daily basis and by
requiring deposits of additional cash as collateral when necessary.
The Company is obligated to settle transactions with brokers and other
financial institutions even if its customers fail to meet their obligations to
the Company. Customers are required to complete their transactions on
settlement date, generally three business days after trade date. If customers
do not fulfill their contractual obligations, the Company may incur losses.
The Company has established procedures to reduce this risk by requiring that
customers deposit cash and/or securities into their account prior to placing
an order.
The Company may at times maintain inventories in equity securities on both a
long and short basis. While long inventory positions represent the Company's
ownership of securities, short inventory positions represent obligations of
the Company. Accordingly, both long and short inventory positions may result
in losses or gains to the Company as market values of securities fluctuate. To
mitigate the risk of losses, long and short positions are marked to market
daily and are continuously monitored by the Company.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
The Company's Proxy Statement for its 1998 Annual Meeting of Stockholders,
which, when filed pursuant to Regulation 14A under the Securities Exchange Act
of 1934, will be incorporated by reference in this Annual Report on Form 10-K
pursuant to General Instruction G(3) of Form 10-K, provides the information
required under Part III (Items 10, 11, 12 and 13), except for the information
with respect to the Company's executive officers who are not directors, which
is included in "Item 1. Business-Executive Officers of the Registrant."
45
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
Consolidated Financial Statements and Financial Statement Schedules
See "Item 8. Financial Statements and Supplementary Data."
(b) Reports on Form 8-K.
During the three month period ended September 30, 1997, the Company
filed an amendment to a Form 8-K originally filed with the Securities
and Exchange Commission on June 13, 1997. The report, dated July 25,
1997, amended financial statements, exhibits or other portions of the
originally filed Form 8-K.
(c) Exhibits.
EXHIBIT
NUMBER DESCRIPTION
------- -----------
3.1 Restated Certificate of Incorporation (Incorporated by reference to
Exhibit 3.3 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
3.2 Restated Bylaws of the Registrant (Incorporated by reference to
Exhibit 3.4 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
4.1 Specimen of Common Stock Certificate (Incorporated by reference to
Exhibit 4.1 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
4.2 Reference is hereby made to Exhibits 3.1 and 3.2.
10.1 Underwriting Agreement dated August 15, 1996, by and among the
Company, Robertson, Stephens & Company LLC, Hambrecht & Quist LLC,
Deutsche Morgan Grenfell/C.J. Lawrence Inc., and the Selling
Stockholders named therein (Incorporated by reference to Exhibit 10.1
of the Company's Annual Report on Form 10-K for the year ending
September 30, 1996.)
10.2 Form of Indemnification Agreement entered into between the Registrant
and its directors and certain officers (Incorporated by reference to
Exhibit 10.1 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
10.3 1983 Employee Incentive Stock Option Plan (Incorporated by reference
to Exhibit 10.2 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
10.4 1993 Stock Option Plan (Incorporated by reference to Exhibit 10.3 of
the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
10.5 1996 Stock Incentive Plan (Incorporated by reference to Exhibit 99.1
of the Company's Registration Statement on Form S-8, Registration
Statement No. 333-12503.)
10.6 401(k) Plan (Incorporated by reference to Exhibit 10.8 of the
Company's Registration Statement on Form S-1, Registration Statement
No. 333-05525.)
10.7 1996 Stock Purchase Plan (Incorporated by reference to Exhibit 99.13
of the Company's Registration Statement on Form S-8, Registration
Statement No. 333-12503.)
10.8 Employee Bonus Plan (Incorporated by reference to Exhibit 10.10 of the
Company's Registration Statement on Form S-1, Registration Statement
No. 333-05525.)
46
EXHIBIT
NUMBER DESCRIPTION
------- -----------
10.9 Lease of premises at Four Embarcadero Place, 2400 Geng Road, Palo
Alto, California (Incorporated by reference to Exhibit 10.11 of the
Company's Registration Statement on Form S-1, Registration Statement
No. 333-05525.)
10.10 Lease of premises at 10951 White Rock Road, Rancho Cordova, California
(Incorporated by reference to Exhibit 10.12 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
10.11 Employment Agreement dated March 15, 1996, by and between Christos M.
Cotsakos and the Registrant (Incorporated by reference to Exhibit
10.13 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
10.12 Clearing Agreement between E*TRADE Securities, Inc. and Herzog, Heine,
Geduld, Inc. dated May 11, 1994 (Incorporated by reference to Exhibit
10.14 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
10.13 Guarantee by the Registrant to Herzog, Heine, Geduld, Inc.
(Incorporated by reference to Exhibit 10.15 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
+10.14 BETAHOST Master Subscription Agreement between E*TRADE Securities,
Inc. and BETA Systems Inc. dated June 27, 1996 (Incorporated by
reference to Exhibit 10.13 of the Company's Registration Statement on
Form S-1, Registration Statement No. 333-05525.)
10.15 Stock Purchase Agreement among the Registrant, General Atlantic
Partners II, L.P. and GAP Coinvestment Partners, L.P. dated September
28, 1995 (Incorporated by reference to Exhibit 10.17 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
10.16 Stock Purchase Agreement among the Registrant, General Atlantic
Partners II, L.P., and GAP Coinvestment Partners, L.P., Richard S.
Braddock and the Cotsakos Group dated April 10, 1996 (Incorporated by
reference to Exhibit 10.18 of the Company's Registration Statement on
Form S-1, Registration Statement No. 333-05525.)
10.17 Stock Purchase Agreement between the Registrant and SOFTBANK Holdings
Inc. dated June 6, 1996 (Incorporated by reference to Exhibit 10.19 of
the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
10.18 Stockholders Agreement among the Registrant, General Atlantic Partners
II, L.P., GAP Coinvestment Partners, L.P. and the Stockholders named
therein dated September 1995 (the "Stockholders Agreement")
(Incorporated by reference to Exhibit 10.20 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
10.19 Supplement No. 1 to Stockholders Agreement dated as of April 10, 1996
(Incorporated by reference to Exhibit 10.21 of the Company's
Registration Statement on Form Registration Statement No. 333-05525.)
10.20 Stockholders Agreement Supplement and Amendment dated as of June 6,
1996 (Incorporated by reference to Exhibit 10.22 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
10.21 Consulting Agreement between the Registrant and George Hayter dated as
of June 7, 1996 (Incorporated by reference to Exhibit 10.23 of the
Company's Registration Statement on Form S-1, Registration Statement
No. 333-05525.)
47
EXHIBIT
NUMBER DESCRIPTION
------- -----------
+10.22 License and Service Agreement between the Registrant and VERSUS
Technologies Inc. dated as of January 21, 1997 (Incorporated by
reference to Amendment No. 1 the Company's Form 8-K filed on July 25,
1997.)
10.23 Form of Loan Agreement between Christos M. Cotsakos and the Registrant
(Incorporated by reference to quarterly report on Form 10-Q for the
quarterly period ending December 31, 1996.)
10.24 Management Continuity Agreement dated as of January 1, 1997 between
the Registrant and Kathy Levinson (Incorporated by reference to
Exhibit 10.24 of the Company's Registration Statement on Form S-1
filed on July 24, 1997, Registration Statement No. 333-31841).
*11.1 Statement regarding computation of per share earnings.
21.1 Subsidiaries of the Registrant (Incorporated by reference to Exhibit
21.1 of the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
*23.1 Consent of Independent Auditors
*27.1 Financial Data Schedule for the fiscal year ended September 30, 1997.
- --------
* Filed herewith
+ Confidential treatment has been requested with respect to certain portions
of this exhibit
48
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
E*TRADE GROUP, INC.
/s/ Christos M. Cotsakos
By: __________________________________
CHRISTOS M. COTSAKOS PRESIDENT,
CHIEF EXECUTIVE OFFICER
AND DIRECTOR
Dated: December 23, 1997
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Christos M. Cotsakos President, Chief December 23, 1997
- ------------------------------------ Executive Officer
(CHRISTOS M. COTSAKOS) and Director
(principal
executive officer)
/s/ Stephen C. Richards Senior Vice December 23, 1997
- ------------------------------------ President, Finance
(STEPHEN C. RICHARDS) and
Administration,
Chief Financial
Officer and
Treasurer; Chief
Financial Officer
of E*TRADE
Securities, Inc.
(principal
financial and
accounting
officer)
/s/ William A. Porter Chairman of the December 23, 1997
- ------------------------------------ Board
(WILLIAM A. PORTER)
/s/ Richard S. Braddock Director December 23, 1997
- ------------------------------------
(RICHARD S. BRADDOCK)
/s/ William E. Ford Director December 23, 1997
- ------------------------------------
(WILLIAM E. FORD)
/s/ George Hayter Director December 23, 1997
- ------------------------------------
(GEORGE HAYTER)
/s/ Keith Petty Director December 23, 1997
- ------------------------------------
(KEITH PETTY)
/s/ Lewis E. Randall Director December 23, 1997
- ------------------------------------
(LEWIS E. RANDALL)
/s/ Lester C. Thurow Director December 23, 1997
- ------------------------------------
(LESTER C. THUROW)
49